Causes of Economic Inflation
Economic inflation is a sustained increase in the general price level of goods and services over time, eroding purchasing power. It is primarily caused by demand-pull factors, where aggregate demand exceeds supply, leading to higher prices; cost-push factors, such as rising production costs from wages or raw materials; and built-in inflation, driven by adaptive expectations where workers demand higher wages to keep up with past price increases. These causes interact, often amplified by monetary expansion when too much money chases too few goods.
Key Principles of Inflation Dynamics
Inflation operates through the quantity theory of money, where the money supply growth outpacing economic output leads to price rises. Demand-pull inflation occurs in booming economies with high consumer spending and low unemployment, while cost-push inflation arises from supply shocks like oil price hikes. Built-in inflation perpetuates the cycle via wage-price spirals. Central banks monitor indicators like the Consumer Price Index (CPI) to quantify inflation rates, typically targeting 2% annually for stable growth.
Practical Example: The 1970s Stagflation
In the 1970s, many Western economies, including the United States, experienced stagflation—a combination of high inflation and stagnation—due to cost-push factors from the OPEC oil embargo, which quadrupled oil prices. This increased production costs, pushing up prices while slowing growth. Combined with loose monetary policy post-Vietnam War, inflation peaked at over 13% in the US by 1980. The Federal Reserve's subsequent tight monetary policy under Paul Volcker raised interest rates to nearly 20%, curbing inflation but inducing a recession.
Strategies to Control Inflation
Governments and central banks control inflation through monetary policy, such as raising interest rates to reduce borrowing and spending, or conducting open market operations to shrink money supply. Fiscal policy tools include reducing government spending or increasing taxes to cool demand. Supply-side measures, like improving productivity or deregulating markets, address cost-push causes. In extreme cases, like hyperinflation, currency reforms or pegging to stable currencies are used. Effective control balances inflation reduction with avoiding deflation or deep recessions.