There are two primary types of inflation: demand-pull and cost-push. Understanding which type of inflation is occurring at any given point in time is important if policymakers want to respond appropriately. The two types of inflation are not mutually exclusive, so it is possible for both to occur simultaneously. Left untreated, inflation can cause a wage-price spiral or even hyperinflation.
Demand-pull inflation occurs when spending on goods and services drives up prices. In other words, aggregate demand is greater than aggregate supply. Demand-pull inflation is fueled by income, so efforts to stop it involve reducing consumers’ income or giving consumers more incentive to save than to spend.
The inverse relationship that exists between the real GDP and the price level in the economy. Aggregate demand (AD) is the willingness and ability of households, firms, government, and the foreign sector to buy the new, domestic production of a nation.
The real gross domestic product that firms are willing to produce at each and every price level. In the short run, real GDP and price level are directly related, but in the long run, real GDP is independent of the price level.
Demand-pull inflation persists if the public or foreign sector reinforces it. Low taxes and profligate government spending exacerbate demand-pull inflation. A failure of the central bank to reign in the money supply also makes the demand-pull inflation worse.
Demand-pull inflation can spread across borders as well. China’s and India’s economic growth not only puts pressure on prices in these countries, but also prices worldwide as the demand for imports increase.
Asset inflation is a type of inflation that occurs only in a specific industry, such as the housing market, and can happen when overall inflation is otherwise low. This creates what is popularly called a “bubble,” where prices rise quickly, beyond a sustainable point. It can be made worse by a supply shortage. Eventually the market collapses, rapidly devaluing the assets in that class.
If government spending is financed by printing currency or by the central bank monetizing the debt, demand-pull inflation can become hyperinflation. Hyperinflation is defined as annual inflation of 100% or greater. All cases of hyperinflation have been accompanied by the government or central bank issuing too much money.
Monetizing the debt refers to the process by which the central bank buys new government debt, thus increasing the supply of money in circulation. When debt is monetized, the government is able to spend without raising taxes or borrowing from the private sector. The downside is that debt monetization is extremely inflationary.
Cost-push inflation occurs when the price of inputs increases. Businesses must acquire raw materials, labor, energy, and capital to operate. If the price of these were to rise, it would reduce the ability of producers to generate output because their unit cost of production had increased. If these increases in production cost are relatively large and pervasive, the effect is to simultaneously create higher inflation, reduce real GDP, and increase the unemployment rate.
You might recognize the combination of higher inflation, reduced real GDP, and increased unemployment by another name: stagflation. In the 1970s, OPEC cut oil production, which led to much higher energy prices along with double-digit inflation and unemployment. Because producers faced higher operating costs, they reduced output. Relative to the demand for their products, the supply decreased, which resulted in cost-push inflation.
If cost-push inflation has a bright side, it is the fact that it is self-limiting. Cost-push inflation is associated with decreases in GDP. The decreased GDP and resulting high unemployment helps to bring producer prices back down. The trick to combating cost-push inflation is realizing that it is not demand-pull. The policy prescription for each is different, and applying the wrong prescription can create more problems than it solves.
Everything that is owned by an individual or firm. For banks, assets include its reserves, loans to customers, securities, and real estate.
It is the unemployment issue that usually spurs policymakers to action. If they respond to the increased unemployment by increasing spending, the inflation problem is made worse. A wage-price spiral can result if the policy responses create more demand for goods and services at the same time that unit costs are rising. By way of analogy, the prescription for a grease fire is different from that of a forest fire. Grease fires are put out by removing the source of oxygen, while a forest fire is extinguished with water. If you pour water on a grease fire, then things only get worse. This is what happened in the 1970s. Instead of letting cost-push inflation run its natural course, the Fed poured money on it, and inflation worsened.
A small amount of inflation is considered healthy for the economy, as the anticipation that prices will rise increases demand. This increased demand helps the economy expand. But when inflation jumps higher, demand increases too much (as people anticipate much higher prices), creating demand-pull inflation and ever-higher prices. The magic number seems to be 2%. At a 2% annual rate of inflation, prices are relatively stable and slow-growing. A 2% inflation rate results in prices doubling about every thirty-six years.