When an economy experiences a rise in the prices of goods and services, it is called inflation. During a period of inflation, the value of a currency is also decreased because it can no longer purchase the same amount of goods. There are various causes of inflation.
Causes of inflation in Economics
1. Cost-Push inflation
Among the primary causes of inflation is cost-push inflation, as the name suggests, in this, the production cost is raised, pushing the prices of the products up. The reason behind this is an increase in the production rate due to increased consumer demand. Expectedly, the price of raw materials is increased as well, resulting in companies charging more for their services and products. Take the oil crisis in the United States, for example, the oil demand was increasing during the 1970s; however, the Organization of Petroleum Exporting Countries (OPEC), which supplied oil to the US, stopped its supply, resulting in soaring prices of the oil, causing inflation.
2. Demand-pull inflation
Demand-pull inflation is identical to cost-push inflation except it applies to specific segments, i.e., the demand for a certain product or service is increased, causing inflation, as the supply is not able to keep up. This largely affects households, businesses, governments, and foreign buyers. An example of demand-pull inflation would be the rise in demand for vaccines amidst the coronavirus pandemic. In 2020, the rate of vaccination increased exponentially; however, the supply was not met, resulting in the increased price of vaccines.
3. Printing Money
Since government likes to control the economy to introduce more jobs and better the infrastructure of the nation, it can print money to do so. A huge downside to printing money is that within a short duration, the value of the currency drops, resulting in inflation. Another cause for printing money could be to balance deficit financing, i.e., when the government spends more than the generated revenue. Interestingly, printing money can also result in hyperinflation. This is what happened in Hungary in the 20th century, as the inflation rate rose to 41.9 quadrillion percent in July 1946.
4. Public Spending
When the spending by the state is increased, it results in an increase in inflation. As the government has the financial means to purchase more goods and services because of increased aggregated demand, it results in competition within the private sector for specific goods and services. This causes the prices of commodities to increase, resulting in inflation. Public spending inflation is mostly observed in developing countries. For instance, the introduction of new pension plans.
5. Velocity of Circulation
An increased velocity of circulation means that the same amount of money is used in an increased number of transactions. The velocity of circulation usually increases during the expansion phase of an economy. It is measured by dividing GDP by the country’s total money supply. For instance, the roaring twenties in the United States. Following the First World War, each aspect of the economy was seeing significant growth, causing people to spend more, and in turn, increasing inflation.
The entire economic system revolves around the demand of the consumer and the supply to the consumer. Therefore, it is easy to understand that once there is a surge in the number of consumers, i.e., growth in population, it raises the demand causing inflation.
Once people or entities stockpile commodities and refuse to release them in the market, it results in an artificial demand. By proving the ‘demand’ for certain products and services, stockpilers can increase prices, causing inflation. De Beers, one of the leading diamond companies in the world, carried out unethical business practices during the 20th century by hoarding diamonds, causing a fake demand surge.
Unlike hoarding, where the shortage of goods and services is deliberate, a genuine shortage can result in inflation in multiple sectors. Shortage can arise for many reasons, such as low production rate, logistics, or a natural calamity. In 2020, the price of toilet paper significantly increased due to the short supply.
The total production of an economy comprises production for both domestic and foreign markets. Therefore, the inability to meet the export criteria can cause pressure on domestic production, resulting in inflation.
10. Trade Union
This can also be considered wage inflation. Trade unions work exclusively for the benefit of the workers, therefore, once the prices of goods and services increase, trade unions demand wage increments. Increased wages result in increased production costs, and subsequently, inflation.
While the value of the currency lowers during inflation, deliberate devaluation of the currency also causes inflation. This affects international trade tremendously, as foreign companies rush to purchase both the finished products and raw materials at a devalued price, resulting in inflation. China, for instance, devalues its Yuan to attract foreign buyers.
12. Tax Reduction
Once taxes are reduced by the state, people are more than likely to use their assets. Lower taxes also mean the demand for goods and services increases; however, when the production rate is not able to match the demand, it results in inflation.