In our previous article, we took a look at the definition of inflation, and its different types. In our latest piece, we examine the causes of inflation.
Demand-Pull Inflation
“Demand-pull” inflation is one of the traditional causes of inflation. This occurs when a government or central bank boosts the money supply to stimulate the economy. By lowering interest rates and giving money to banks in the hopes that they will increase credit, the money supply is typically increased indirectly. But central banks can also print money, which can be used in a far more direct way to purchase assets.
In any case, there is more money vying for the same number of commodities, which ought to increase both demand and price. As a result of increased demand for their products, businesses will increase output. This in turn boosts employment and economic growth. However, businesses increase their pricing to catch up, and employees demand higher compensation. As a result, the economy’s output returns to its original level but inflation increases.
Wage Spirals
Additionally, if businesses and employees begin to worry that inflation will spiral out of control, they may get caught in a vicious cycle known as a wage-price spiral. In this case, workers demand more pay to keep up with rising costs, forcing businesses to raise pricing to keep up with rising costs. As things worsen, those who still have money in savings seek to move it somewhere else, store it in “real” assets like gold, or just spend it as soon as possible by exchanging it for products. This can make it challenging for companies to raise capital.
Causes Of Inflation – Hyperinflation
When hyperinflation is severe, individuals may start bartering instead of using money because it will become worthless (or a shadow currency). Germany in the early 1920s is a prime illustration of this. Germany, in contrast to France and Britain, printed more money to cover the expenditures of World War I. As a result, prices rose and the value of the mark was significantly diminished. It was also required to make significant financial restitution. It turned to the printing presses as a result of the war’s economic devastation. The work was more difficult because the reparations were made in gold and a foreign currency, requiring the central bank to produce more and more marks to pay off the same amount of debt. At its peak, shop owners were rising prices multiple times in a single day.
Cost-Push Inflation (Stagflation)
Because it is simpler to predict, demand-pull inflation is the main concern of most analysts. “Inflation is always and everywhere a monetary phenomenon,” remarked economist Milton Freidman. But in addition to demand, changes in the cost base can also lead to inflation. This kind of inflation almost invariably causes price increases without increasing demand.
Because businesses are also under pressure to cut costs and frequently look to lay off employees, consumers must pay higher prices while their incomes do not increase to make up the difference. Occasionally, this is referred to as a “supply-side shock.” When unemployment and inflation are both high, it is known as “stagflation.”
Causes of Inflation – An Example
The Western economies in the 1970s are a prime example of this. Following the Arab-Israeli war, Arab nations decided to first increase oil prices before deciding to boycott the West. As a result, the price of oil increased fourfold in less than a month. In the UK, inflation reached a maximum of 25% in 1975. Overall, researchers believe that the increase reduced US GDP by much to 8%.
A second significant increase in oil prices was brought on by the Iranian revolution in 1979. Once more, this had a negative impact on Western economies. Inflation in the US peaked at 15% per year in the beginning of 1981. 7.6 percent was a record high for unemployment during that time. It required a strict interest rate increase policy from the central bank to bring inflation down, but at the expense of unemployment rates.
Deflation
We have so far only discussed price increases. Deflation, however, results from inflation that is too low or even negative. Here, the cost-push inflation process reverses course. Here, demand is impacted by a decrease in the money supply or a reduction in government spending. Profits for the company suffer as fewer products are purchased. Because salaries are sticky on the downside (it’s difficult to make employees take pay cuts), businesses usually cut output instead, which means they lay off workers and produce less.
As a result, both employment and economic growth decline. Prices and wages should naturally stabilise at lower levels over time. This procedure, frequently referred to as a “internal devaluation,” can, however, be drawn-out and traumatic. Deflation harms debtors in the same way that unforeseen inflation damages creditors (by decreasing the value of their savings) (by driving up the real cost of servicing their debt).
The Great Depression is regarded as the archetypal instance of a deflationary period.
Another Example
The Japanese economy in the 1990s is another such. A housing and stock market bubble emerged in the 1980s as a result of a credit boom. The government raised interest rates in try to burst it. Deflation and greater unemployment were caused by the money supply’s following steep decline. Large amounts of bad debt were also left behind. Even though the money supply will eventually stabilise, it was not growing rapidly enough to increase demand. Prices either remained the same or decreased as a result, which made growth even slower. Japan’s “lost decade” is the term used to describe this protracted period of recession or stagnation.
