Lesson preview · Inflation Causes
Causes of Inflation
~12 min · Free to read
Every inflation episode in history has one of two engines — sometimes both at once. Either demand is running too hot for the economy to keep up, or supply is seizing up and the same amount of demand is chasing fewer goods. Economists call these demand-pull and cost-push inflation.
Key Term
Demand-pull inflation
Too much money chasing too few goods. Spending grows faster than the economy can produce; firms hit capacity; prices rise. In AD–AS language (covered in Unit 5), the AD curve shifts right along an upward-sloping short-run AS.
Key Term
Cost-push inflation
An input gets expensive — oil, wages, shipping containers — and firms pass the cost on. Output falls and prices rise at the same time. This is the recipe for stagflation. In AD–AS language, the short-run AS curve shifts left.
The colours make the point: every big move has an engine behind it, and it’s almost always demand-pull, cost-push, or both. The 1970s were cost-push (oil); 2021–22 was both at once; 2009 was demand collapsing the other way.
Expectations add a third layer to both engines. If everyone expects prices to rise 5% next year, workers ask for 5% raises, firms post 5% higher prices, and lenders demand 5% extra interest. The expectation becomes self-fulfilling. This is why central bankers obsess about expectations — once they unanchor, inflation is much harder to bring down.
Key Term
Inflation expectations
What households, firms, and lenders expect future inflation to be. Surveys (University of Michigan, NY Fed) measure this directly. When expectations are anchored near the 2% target, central bankers can fight a shock with patience. When they un-anchor — as they did in the late 1970s — bringing inflation back down costs a recession.
Over the long run, persistent inflation has one common ingredient: too much money relative to the goods being produced. This is the monetarist view, summarised in a single identity.
The quantity equation. M = money supply, V = velocity (how often money turns over), P = price level, Y = real output.
Tip
Three textbook examples
- 1970s US (cost-push + accommodative money). Two oil shocks pushed AS left. The Fed let money supply keep growing rather than cause a recession. Both engines firing → inflation hit 14% by 1980.
- 2021–2023 US (demand-pull + cost-push). Massive fiscal stimulus and easy money lifted AD. Supply chain breakdowns lifted costs. Headline inflation peaked at 9.1% in June 2022.
- Hyperinflations (1920s Germany, 2008 Zimbabwe, 2018 Venezuela). Almost always governments printing money to finance budget deficits. Persistent growth → persistent growth → currency collapse.
Trap · Common Misconception
Inflation isn't just one thing
Headlines often pick a single cause and run with it — “It’s the Fed!” or “It’s the supply chain!” or “It’s the stimulus!”. Most inflation episodes are several things at once. The 2021–23 US inflation had supply shocks, fiscal stimulus, and pent-up demand all firing together. Look for the dominant driver but don’t ignore the supporting cast.
Check yourself · no marks
A central bank doubles the money supply, but at the same time velocity falls by half. What happens to nominal GDP (P × Y)?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
An economy has a money supply M = 1,000, velocity V = 4, and real output Y = 2,000. Compute the implied price level P. Then suppose the central bank doubles M while V and Y stay constant. What does the price level do?
Practice · 1 / 4
Which of the following best describes cost-push inflation?
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