Understanding Inflation in Macroeconomic Theory
Inflation in macroeconomic theory refers to a sustained increase in the general price level of goods and services over time, eroding purchasing power. It is primarily driven by three core factors: demand-pull, cost-push, and built-in inflation. These elements interact within the economy to create upward pressure on prices, as explained by models like the Phillips Curve and quantity theory of money.
Key Drivers: Demand-Pull, Cost-Push, and Built-In Inflation
Demand-pull inflation occurs when aggregate demand exceeds aggregate supply, often due to increased consumer spending, government expenditure, or investment, leading to higher prices. Cost-push inflation arises from rising production costs, such as wages or raw materials, which businesses pass on to consumers. Built-in inflation stems from adaptive expectations, where workers demand higher wages to keep up with past inflation, perpetuating a wage-price spiral.
Practical Example: The 1970s Oil Crisis
During the 1970s oil crisis, OPEC's supply restrictions caused oil prices to surge, exemplifying cost-push inflation. This increased production costs globally, leading to widespread price hikes. Combined with strong demand from post-war recovery, it created stagflation—high inflation alongside economic stagnation—highlighting how external shocks can amplify inflationary pressures.
Importance and Real-World Applications
Understanding these factors is crucial for policymakers to maintain economic stability. Central banks, like the Federal Reserve, use tools such as interest rate adjustments to counteract demand-pull inflation. Addressing cost-push requires supply-side policies, while managing built-in inflation involves anchoring expectations through credible monetary policy. This knowledge helps mitigate risks like hyperinflation or recession.