why does inflation happen?
There are a lot of factors to consider on why Inflation happens. But either way, general knowledge says that the main causes of inflation are either excess aggregate demand (economic growth too fast) or cost push factors (Supply side factors). To explain further:
Main Causes of Inflation
1. Demand-Pull Inflation
Demand-Pull Inflation is the most common. It's simply when demand for a good or service increases so much that it outstrips supply. If sellers maintain the price, they will sell out. They soon realize now have the luxury of raising prices, creating inflation.
Many circumstances can lead to demand-pull inflation. A growing economy can create some inflation as people feel confident about the future and spend more. As long as inflation stays within limits, this could actually benefit economic growth. That's because it creates an expectation of inflation, which can contribute to further demand-pull inflation. As people expect further inflation, they make their purchases sooner to avoid further price increases. The Federal Reserve has set an inflation target to manage the public's expectation of inflation. The inflation target is currently set at 2%, as measured by the core inflation rate. This removes the effect of seasonal food and energy increases.
Discretionary fiscal policy contributes to demand-pull inflation. The government's ability to spend more or tax less increases demand in certain areas of the economy. Marketing and new technology can create demand-pull inflation for certain products or asset classes. For example, the Apple brand commands higher prices, a type of inflation, for its products. New technology, in the form of financial derivatives, created asset inflation in the housing market in 2005-2006.
1. Demand-Pull Inflation
Demand-Pull Inflation is the most common. It's simply when demand for a good or service increases so much that it outstrips supply. If sellers maintain the price, they will sell out. They soon realize now have the luxury of raising prices, creating inflation.
Many circumstances can lead to demand-pull inflation. A growing economy can create some inflation as people feel confident about the future and spend more. As long as inflation stays within limits, this could actually benefit economic growth. That's because it creates an expectation of inflation, which can contribute to further demand-pull inflation. As people expect further inflation, they make their purchases sooner to avoid further price increases. The Federal Reserve has set an inflation target to manage the public's expectation of inflation. The inflation target is currently set at 2%, as measured by the core inflation rate. This removes the effect of seasonal food and energy increases.
Discretionary fiscal policy contributes to demand-pull inflation. The government's ability to spend more or tax less increases demand in certain areas of the economy. Marketing and new technology can create demand-pull inflation for certain products or asset classes. For example, the Apple brand commands higher prices, a type of inflation, for its products. New technology, in the form of financial derivatives, created asset inflation in the housing market in 2005-2006.
2. Cost-Push Inflation
A second cause of inflation is cost-push inflation. This isn't as common as demand-pull inflation, because it only occurs when there is a shortage of supply combined with enough demand to allow the producer to raise prices. Wage inflation can contribute to cost-push inflation. This is usually caused by strong labor unions. A company with the ability to create a monopoly can also create cost-push inflation. That's because controls the supply of a good or service. Monopolies were outlawed in 1890 by the Sherman Anti-Trust Act.
Natural disasters can temporarily create cost-push inflation by damaging production facilities, such as what happened to oil refineries after Hurricane Katrina. The depletion of natural resources will be a growing cause of cost-push inflation. For example, over-fishing reduces the supply of seafood, driving up prices.Government regulation and taxation also reduce supplies. For example, subsidies of corn ethanol production reduced the amount of corn available to feed people and animals. This shortage created food price inflation in 2008.
A second cause of inflation is cost-push inflation. This isn't as common as demand-pull inflation, because it only occurs when there is a shortage of supply combined with enough demand to allow the producer to raise prices. Wage inflation can contribute to cost-push inflation. This is usually caused by strong labor unions. A company with the ability to create a monopoly can also create cost-push inflation. That's because controls the supply of a good or service. Monopolies were outlawed in 1890 by the Sherman Anti-Trust Act.
Natural disasters can temporarily create cost-push inflation by damaging production facilities, such as what happened to oil refineries after Hurricane Katrina. The depletion of natural resources will be a growing cause of cost-push inflation. For example, over-fishing reduces the supply of seafood, driving up prices.Government regulation and taxation also reduce supplies. For example, subsidies of corn ethanol production reduced the amount of corn available to feed people and animals. This shortage created food price inflation in 2008.
Cost-Push Inflation can be caused by many factors:
1. The Labour MarketIf trades unions can present a common front then they can bargain for higher wages, this will lead to wage inflation.
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation
e.g. A German car costs DM 40,000. If the exchange rate is DM £1:3DM then it will be priced at £13,333.
If the E.R falls to £1 : 2DM then it will be priced at £20,000
3. Raw Material Prices
The best example is the price of oil, if the oil price increase by 20% then this will have a significant impact on most goods in the economy and this will lead to cost push inflation.
e.g. in early 2008, there was a spike in the price of oil to over $150 causing a rise in inflation.
4. Profit Push Inflation
When firms push up prices to get higher rates of inflation.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
1. The Labour MarketIf trades unions can present a common front then they can bargain for higher wages, this will lead to wage inflation.
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation
e.g. A German car costs DM 40,000. If the exchange rate is DM £1:3DM then it will be priced at £13,333.
If the E.R falls to £1 : 2DM then it will be priced at £20,000
3. Raw Material Prices
The best example is the price of oil, if the oil price increase by 20% then this will have a significant impact on most goods in the economy and this will lead to cost push inflation.
e.g. in early 2008, there was a spike in the price of oil to over $150 causing a rise in inflation.
4. Profit Push Inflation
When firms push up prices to get higher rates of inflation.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
Seeing the main causes of Inflation then, it is important to note that once inflation sets in it is difficult to reduce it. For example, higher prices will cause workers to demand higher wages causing a wage price spiral. The attitude of the monetary authorities is important for example if there was an increase in AD and the monetary authorities accomodated this by increasing the money supply then there would be a rise in the price level
