Inflation Causes

Inflation is a key concept in AP Macroeconomics, impacting purchasing power and economic stability. Understanding its causes, like demand-pull and cost-push inflation, helps explain how various factors influence prices and overall economic health.

1. Demand-pull inflation

   • Occurs when aggregate demand in an economy outpaces aggregate supply.
   • Often driven by increased consumer spending, government expenditure, or investment.
   • Can lead to higher prices as businesses respond to increased demand.

2. Cost-push inflation

   • Results from rising costs of production, leading to decreased supply of goods.
   • Common causes include increased wages, higher raw material prices, or supply chain disruptions.
   • Businesses pass on higher costs to consumers, resulting in increased prices.

3. Monetary policy (expansionary)

   • Involves increasing the money supply or lowering interest rates to stimulate economic activity.
   • Aims to boost spending and investment, which can lead to higher demand and inflation.
   • Central banks may implement this policy during economic downturns to encourage growth.

4. Fiscal policy (expansionary)

   • Involves increased government spending or tax cuts to stimulate the economy.
   • Aims to boost aggregate demand, which can lead to higher inflation if the economy is near full capacity.
   • Often used during recessions to promote economic recovery.

5. Supply shocks

   • Sudden and unexpected events that significantly disrupt supply chains or production.
   • Can lead to shortages of goods, driving prices up (e.g., natural disasters, geopolitical events).
   • Often results in cost-push inflation as businesses struggle to meet demand.

6. Wage-price spiral

   • Occurs when rising wages lead to increased production costs, prompting businesses to raise prices.
   • Higher prices can lead workers to demand even higher wages, creating a cycle of inflation.
   • This phenomenon can be self-perpetuating and difficult to control.

7. Built-in inflation (expectations)

   • Refers to inflation that is expected by consumers and businesses, influencing their behavior.
   • If people expect prices to rise, they may spend more now, increasing demand and driving prices up.
   • This can create a feedback loop where inflation expectations become reality.

8. Currency devaluation

   • Occurs when a country's currency loses value relative to other currencies.
   • Makes imports more expensive, leading to higher prices for imported goods and services.
   • Can stimulate exports but may also contribute to inflation if domestic prices rise.

9. Increase in money supply

   • When the central bank increases the amount of money circulating in the economy.
   • Can lead to higher spending and investment, boosting aggregate demand and potentially causing inflation.
   • If the increase outpaces economic growth, it can lead to excessive inflation.

10. Decrease in aggregate supply

    • Occurs when the overall supply of goods and services in the economy declines.
    • Can be caused by factors like natural disasters, increased production costs, or regulatory changes.
    • Results in higher prices as demand remains constant or increases while supply falls.