Common Cents

Alright, gather round. This is going to be important.

What are the causes of inflation?

As promised, let’s talk about what causes inflation. As a reminder, inflation is the increase in prices over time. In other words, things get more expensive as time goes by. Check out the previous post “What is inflation?” for more information.

We take for granted this idea of prices going up over time, but really, why would they? I don’t think anyone wants to pay more for bread and milk tomorrow than they do today, and yet prices go up anyway. So what gives?

It all boils down to this: the economy never stands still. Things change in the economy everyday and these changes can be big or small. Regardless of size, these everyday changes usually eventually lead to inflation, with the big ones having a noticeable impact for most people and the smaller ones mostly going under the radar. To sum it up: economic activity and growth leads to inflation.

Okay, but why would that be the case? Why does my buying a car lead to inflation?

Demand-pull inflation

To understand why economic activity, like buying a car, leads to inflation, let’s start with a smaller example.

Let’s say you run a cereal factory and, wouldn’t you know it, one of your cereal brands is shown to decrease the risk of heart disease in most people. As a result, lots of people rush to stores to try to buy it. What would you do in this case?

Sell more cereal, I guess? It’s never that simple though.

Good intuition. It isn’t that simple! For better or worse, companies exist to make money. That’s the whole point of capitalism. So, if everyone suddenly wants your cereal, do you just sell all the boxes you have and do nothing else?

I’m guessing the answer is ‘no’.

Indeed. Let me put it to you this way: you have a box of this magical cereal you make and there are two people who want to buy it from you. One offers you $3.00 for the box and the other offers you $5.00. Who will you sell it to? Before you answer, let me remind you that, as a company, your whole purpose for existing is to make as much money as you can.

Well, I guess I’d sell it to the person offering $5.00 then. They’re offering more for the box and I only have the one left, so I’d sell it for the most money I could.

Of course you would! You’re trying to make as much money as you can. That’s how capitalism works, again for better or worse. Let’s generalize it a bit further: What if there’s suddenly that huge spike in demand for your cereal because of the heart health effects and people are willing to pay much more for the same box? Say, $10.00 a box?

I’d sell it at $10.00 a box then I guess.

And that causes the price to rise. Congratulations, you’ve created inflation. Looking even more generally, when something in the economy causes demand for all, or at least most, goods to increase, then inflation results. This is called “demand-pull” inflation. People want more things than are available, so companies charge more, so everything costs more. Economic activity leads to inflation.

An example of this type of inflation was the pandemic of 2020. People quarantined themselves, cooked mostly at home, and cut all non-essential purchases for quite a long time, to be prepared for the worst. As the pandemic subsided, many households found they had built up significant savings from not buying anything and essentially “caught up” on all the purchases they didn’t make during the pandemic. Although this sudden increase in demand wasn’t the only cause of inflation following the pandemic, it did massively increase demand for most goods, driving up their prices, and helping to spur inflation.

Okay, that makes sense. What other types of inflation are there?

Cost-push inflation

Well, if a change in demand can pull up inflation, then a change in cost for suppliers can push up inflation in a similar way.

Ah right. Companies want to make more money, so they charge more for the same stuff over time. That higher cost just gets pushed onto customers. That’s called “greedflation”, right?

Well, kind of. If all companies just jacked prices up like crazy for no reason, it would be very easy for a competitor to swoop in and offer the same goods for cheaper. People would flock to the cheaper product and the overly-greedy companies would go out of business. That said, companies do charge the absolute highest price they can get away with and this can raise prices, especially during times of economic trouble. This is indeed commonly called “greedflation”, although it should be said evidence for pure greedflation happening in many cases is pretty scarce.

Much more commonly, cost-push inflation occurs when costs suddenly rise for companies. As their input prices rise, they have to also raise the prices on the goods they make, resulting in inflation.

Right, again, so cost increases just get passed on to the customer.

Well… yeah? I mean, really, what else can companies do? If they don’t raise their prices when their costs rise, they can go out of business and then nobody gets anything they want. Admittedly many companies’ first strategy for dealing with higher costs is to just pass them on to customers, but many other companies do try to cut costs where they can, rather than raising prices. Even that is sometimes not enough and prices have to rise.

And we get inflation.

And we get inflation. One type of inflation to go!

Government-induced inflation

Ah I’ve heard of this one! The government prints money to pay off their debts, leading to a spike in inflation, because printing money causes inflation.

That’s almost completely right, yes! The government “prints money” via the Federal Reserve banking system, although in practice the printing of physical money only accounts for a small amount of the overall “money creation”. And it is true that money creation causes inflation, but that’s not entirely a bad thing.

Money creation over time helps to keep the economy growing steadily as people will use the new money to do things like buy houses or increase the wages of workers. Again, over time, this continuous injection of new money causes slow, consistent inflation and, importantly, consistent growth. Additionally, the government can print more money, when demand is low or the economy is in recession, to help get more money into peoples’ pockets during downturns. People in turn will want to buy more things and, in this way, the government can help keep the economy healthy and growing, even during economic troubles.

Sure, but don’t governments print too much money and cause too much inflation?

They sure do. Money creation becomes a problem when the government puts too much money into the economy too quickly. As people become more and more flush with cash, they start to buy lots of things. Too many things in fact. And as they start to buy more and more, demand-pull inflation kicks in and we have inflation again, causing prices to rise. As you mentioned, printing money can help governments pay down their debt, but, as people buy more and expect the inflation to continue, a phenomenon known as “hyperinflation” can occur. Hyperinflation causes money to lose value extremely quickly, leading to the kinds of crazy scenes you might have seen pictures of, with the person hauling a mountain of cash in a wheelbarrow to pay for groceries. Needless to say, this is not a great outcome for anyone.

So it’s very important the government creates money, but not too much money.

Okay, that all makes sense. I read the third kind of inflation was “built-in” inflation though. Why are you saying it’s not?

Well, some sources do say the last type of inflation is “built-in” inflation and they define this type of inflation as inflation caused by workers demanding higher wages, which leads to higher wages being paid, which leads to more purchases, which leads to demand-pull inflation. But I think of that as a combination of cost-push (higher wages mean higher costs for companies) and demand-pull inflation, and not as a separate type in and of itself. Calling the third kind of inflation “built-in” inflation also ignores entirely the huge role the government plays in creating inflation. So, for me, I think it’s more important to highlight governments’ responsibility in creating inflation.

Got it. So, if we have high inflation, how do we stop it?

Great question! More on that in the next post.

Thanks for reading.