Causes of Inflation

Why This Matters

Inflation isn't just one phenomenon—it's the result of multiple forces that can push prices up from different directions. On the AP Macroeconomics exam, you're being tested on your ability to identify where inflationary pressure originates: Is it coming from the demand side (too much spending chasing too few goods) or the supply side (rising production costs squeezing output)? Understanding this distinction is essential for analyzing the AD-AS model, predicting policy responses, and explaining real-world economic events.

The causes of inflation connect directly to core concepts you'll see throughout the course: aggregate demand shifts, short-run aggregate supply movements, monetary policy transmission, fiscal multipliers, and the quantity theory of money. When you encounter an FRQ asking you to explain why prices rose or to recommend a policy response, you need to diagnose the underlying cause first. Don't just memorize these inflation types—know which curve shifts, in which direction, and what the graph looks like for each scenario.

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Demand-Side Causes: Too Much Spending

When aggregate demand grows faster than the economy's productive capacity, prices rise. This occurs because consumers, businesses, and governments collectively want more goods and services than the economy can produce at current prices. The AD curve shifts right, pushing up both real GDP and the price level in the short run.

Demand-Pull Inflation

• Aggregate demand exceeds aggregate supply—this is the classic "too much money chasing too few goods" scenario
• Driven by increases in C, I, G, or net exports—any component of AD can trigger this pressure when the economy is near or at full employment
• Associated with low unemployment and economic expansion—tight labor markets mean workers have bargaining power, fueling more spending

Fiscal Policy Expansion

• Increased government spending or tax cuts shift AD right—both tools inject purchasing power into the economy
• Government spending multiplier exceeds the tax multiplier—so direct spending has a larger impact per dollar than equivalent tax cuts
• Creates inflationary pressure when economy is already at or above potential output—this is why contractionary fiscal policy is prescribed for inflationary gaps

Monetary Policy Expansion

• Lower interest rates encourage borrowing and spending—the Fed's primary transmission mechanism for stimulating AD
• Increased money supply reduces the opportunity cost of holding money—consumers and businesses spend rather than save
• Risks overheating the economy—if implemented when output is already near potential, inflation accelerates without lasting GDP gains

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Supply-Side Causes: Rising Production Costs

When production becomes more expensive, firms reduce output and raise prices. The SRAS curve shifts left, creating the painful combination of higher prices and lower real GDP. This is fundamentally different from demand-pull inflation because output falls rather than rises.

Cost-Push Inflation

• Rising input costs reduce aggregate supply—higher prices for raw materials, energy, or labor squeeze profit margins
• SRAS shifts left, raising price level while reducing output—this creates the distinctive stagflation pattern
• Producers pass increased costs to consumers—firms protect margins by raising prices, spreading inflationary pressure through the economy

Supply Shocks

• Sudden, unexpected disruptions to production capacity—natural disasters, geopolitical conflicts, pandemics, or resource scarcity
• Cause immediate leftward shift of SRAS—the 1970s oil embargo is the textbook example
• Create policy dilemmas for central banks—fighting inflation with contractionary policy worsens the output decline, while stimulating output worsens inflation

Decrease in Aggregate Supply

• Structural factors that reduce productive capacity—labor strikes, regulatory burdens, loss of productive resources
• Distinct from temporary shocks—these represent longer-lasting constraints on the economy
• Results in cost-push inflation with persistent output gaps—harder to resolve than demand-side inflation

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Monetary Causes: The Quantity Theory

The quantity theory of money provides a direct link between money supply growth and inflation. According to $MV = PY$, if velocity (V) and real output (Y) are stable, increases in money supply (M) translate directly into higher prices (P).

Increase in Money Supply

• Central bank injects money faster than output grows—the fundamental monetary cause of inflation
• Quantity equation: $MV = PY$—if V is constant and Y is at potential, then $\%\Delta M = \%\Delta P$ (inflation)
• Long-run monetary neutrality—money supply changes affect only nominal variables (prices) in the long run, not real output

Currency Devaluation

• Weaker currency makes imports more expensive—directly raises prices of imported goods and inputs
• Pass-through effect spreads to domestic prices—firms using imported components raise their prices
• Can result from excessive money creation or loss of confidence—often accompanies broader inflationary episodes

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Expectation and Feedback Effects: Self-Fulfilling Inflation

Once inflation takes hold, expectations about future prices can perpetuate it. When workers and firms anticipate rising prices, they adjust wages and prices preemptively, causing the very inflation they expected. This is why central banks monitor inflation expectations so closely.

Built-In Inflation (Inflation Expectations)

• Expected inflation shifts SRAS left—workers demand higher nominal wages to maintain real purchasing power
• Firms raise prices to cover anticipated cost increases—creating a self-reinforcing cycle
• Central bank credibility is crucial—if people trust the Fed to control inflation, expectations stay anchored

Wage-Price Spiral

• Rising wages increase production costs, leading to price increases—the cost-push mechanism feeds back into wage demands
• Higher prices prompt demands for even higher wages—the cycle accelerates if unchecked
• Most dangerous in tight labor markets—workers have leverage to demand raises that match or exceed inflation

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Quick Reference Table

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Self-Check Questions

1. Which two causes of inflation both shift the AD curve right but use different policy tools? What distinguishes their transmission mechanisms?

2. An economy experiences rising prices and rising unemployment simultaneously. Which type of inflation is this, and which curve shifted in which direction?

3. Using the quantity theory of money ($MV = PY$), explain why rapid money supply growth causes inflation when the economy is at full employment.

4. Compare and contrast demand-pull inflation and cost-push inflation in terms of: (a) which curve shifts, (b) what happens to real GDP, and (c) what happens to unemployment.

5. An FRQ describes workers demanding 5% raises because they expect 5% inflation next year, which then causes firms to raise prices by 5%. What concept does this illustrate, and how would you show this on an AD-AS graph?