Economics bank

Monetary policy

Markets

Money

Europe

Monetary Policy - Inflation - Causes

Explanation

The causes of inflation are easiest explained by looking at aggregate supply and demand. As shown by the diagram below, any change in either AS or AD will cause a change in the price level.

If aggregate demand increases to AD1 or aggregate supply decreases to AS2, the price level increases - this is inflation. If both happen together the inflation is even worse. If the inflation is caused by an increase in demand, then it is known as demand-pull inflation. The growth in demand literally pulls up prices. However, if the inflation is caused by a change in aggregate supply, then it is usually known as cost-push inflation. In practice, the two are often linked together as increases in demand may cause labour shortages, which in turn push up wages. Firms, who have to pay the higher wages, are then forced to put their prices up to maintain their margins.

It is also important to look at the role of the amount of money in the economy. The quantity theory of money shows how increased growth in the money supply can cause inflation. This happens because the extra money boosts the level of demand, and so causes demand-pull inflation.

Another problem that can cause inflation is people's expectations of inflation. This sounds odd, but when you consider that people build their expectation of inflation into their wage claim, you can see that this in itself can be a cause of inflation. If you expect inflation to be 5%, you may reasonably expect a wage rise in excess of this. If you manage to get that wage increase, then that may cause further cost-push inflation as firms are then facing higher costs. The higher inflation may then raise people's expectations further - a vicious circle. Expectations can be a bit like a self-fulfilling prophecy! Higher expectations can actually cause higher inflation.

For more detail on each of these, why not have a look at the theories section for the causes of inflation.