Economics Online Tutor
Causes of
Inflation
Inflation can be caused by forces that work on aggregate demand, called
demand-pull inflation; or by forces that work on aggregate supply, called
cost-push inflation.



Demand-Pull Inflation

The aggregate demand / aggregate supply model shows that the price level
increases whenever aggregate demand increases (the AD curve shifts
rightward).  This can be a permanent situation due to continual increases in
the money supply and government spending.  Wars generally create
demand-pull inflation because of government borrowing to finance war efforts.



Cost-Push Inflation

The aggregate demand / aggregate supply model shows that the price level
increases whenever aggregate supply decreases (the AS curve shifts
leftward).  This is not a permanent situation, because the general trend is for
aggregate supply to shift rightward.  Occasionally it can shift leftward due to a
supply shock: a sudden decrease in aggregate supply.  Examples are weather
related reductions in the production of basic foods, large cutbacks in oil
production, and a large increase in the minimum wage.

A supply shock results in both higher prices and lower output.  In this case,
both high inflation and high unemployment can occur at the same time.  This is
called stagflation, and occurred in many industrialized nations during the
1970s.
The Money Supply and Inflation


Perhaps you have heard people say that inflation is always caused by an
over-supply of money, created by government action.  Perhaps you already
believe that to be true.  Many people do.  In that case, the above
explanations for the causes of inflation can be interpreted in terms of the
underlying supply of money.

Consider the following situation:

Suppose that the world supply of oil was suddenly reduced drastically, as
it was in the 1970s.  This would be a classic case of supply shock.  The
aggregate supply curve shifts leftward, resulting in both higher inflation
and higher unemployment.

Now also suppose that the government decides to intervene with stimulus
monetary and/or fiscal policies in order to reduce unemployment.  In this case, the government believes
that the best short run policy would be to stimulate output and employment.  Expansionary government
policy to deal with the situation will shift the aggregate demand curve to the right.

This will create more output and lower unemployment, but will also magnify the inflation problem.  So,
how does the situation coincide with the belief that inflation is always caused by an increase in the
underlying money supply?  After all, the initial inflationary pressures had nothing to do with the money
supply, but the government response did.

Some people will look at the government's reaction first, and say that the money supply caused this
inflation.  Most economists would not agree with that assessment.
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