Causes of inflation

Two main causes

1. Demand-pull inflation comes from the demand side, when total spending outpaces the economy's capacity to produce.
2. Cost-push inflation comes from the supply side, when the costs of producing goods rise.
3. A monetary view adds that excessive growth of the money supply can also drive inflation, as too much money chases too few goods.

Demand-pull chain

1. In a boom, rising consumption, investment, government spending or exports lifts aggregate demand.
2. As the economy nears full capacity, AD shifts right along an upward-sloping SRAS.
3. Firms respond partly by raising prices, so the average price level rises and real output expands.
4. If demand keeps outpacing supply, these price rises persist as sustained inflation.

Cost-push chain

1. A rise in wages or dearer imported inputs, such as an oil-price spike, raises firms' costs of production.
2. To protect their margins, firms pass these costs on, so SRAS shifts left.
3. The average price level rises while real output falls, a mix known as stagflation.
4. Higher inflation expectations can feed further wage and price rises, entrenching the problem.

Matching cause to diagram

1. Label the axes average price level and real output on the AD/AS diagram.
2. Show demand-pull inflation as AD shifting right, raising both the price level and output.
3. Show cost-push inflation as SRAS shifting left, raising the price level while output falls.

Does the cause of inflation matter?

1. The cause matters because the effective cure differs: demand-pull inflation is best tackled by contractionary demand-side policy, such as higher interest rates or tighter fiscal policy, that reins in excess aggregate demand.
2. The same tools can backfire on cost-push inflation, because cutting aggregate demand when SRAS has already shifted left deepens the fall in output and raises unemployment, the stagflation trap; supply-side measures that lower costs fit better there.
3. In practice the two causes often overlap and inflation expectations blur them, so diagnosis is difficult and a mistaken cause leads to the wrong policy.
4. On balance, the cause matters a great deal, though how much depends on whether the pressure comes from demand or supply and on whether inflation is mild or already entrenched by expectations.