Inflation Causes

Why This Matters

Inflation isn't just about prices going up—it's about understanding why they go up and what that reveals about the economy's health. On the AP Macroeconomics exam, you're being tested on your ability to distinguish between demand-side pressures and supply-side disruptions, and to trace how policy decisions ripple through the AD-AS model to affect the price level. The College Board wants you to connect monetary phenomena, fiscal actions, and market shocks to their inflationary consequences.

Don't just memorize that "more money causes inflation." Know which mechanism is at work: Is aggregate demand shifting right? Is short-run aggregate supply shifting left? Is velocity changing? Each cause of inflation tells a different economic story and requires a different policy response. Master the why behind each cause, and you'll be ready to tackle any FRQ that asks you to explain, graph, or compare inflationary scenarios.

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Demand-Side Causes: Too Much Spending Chasing Goods

When aggregate demand increases faster than the economy's productive capacity, prices rise. This is the classic "too much money chasing too few goods" scenario—the AD curve shifts right while LRAS stays put.

Demand-Pull Inflation

• Aggregate demand exceeds aggregate supply—this occurs when consumers, businesses, and government collectively want more goods than the economy can produce at current prices
• Driven by spending surges from increased consumer confidence, business investment, government purchases, or net exports
• Graphically shown as AD shifting right, causing both real GDP and the price level to rise in the short run—a key FRQ skill

Expansionary Fiscal Policy

• Government spending increases or taxes decrease to stimulate aggregate demand—this is discretionary fiscal policy in action
• Inflationary when economy is near full employment; if there's no slack in the economy, the spending boost pushes prices up rather than output
• The spending multiplier amplifies the effect—remember, the government spending multiplier ($\frac{1}{1-MPC}$) is greater than the tax multiplier

Expansionary Monetary Policy

• Central bank increases money supply or lowers interest rates to encourage borrowing, spending, and investment
• Works through the interest rate channel—lower rates make loans cheaper, boosting consumption and investment demand
• Short-run effect raises both output and price level; in the long run, only the price level increases as the economy returns to potential GDP

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Supply-Side Causes: Production Costs Rising

When it becomes more expensive to produce goods, firms cut back supply and raise prices. The SRAS curve shifts left, creating the painful combination of higher prices and lower output.

Cost-Push Inflation

• Rising production costs reduce aggregate supply—this shifts the SRAS curve leftward, raising the price level while decreasing real GDP
• Common triggers include higher wages, raw material prices, or energy costs—anything that makes production more expensive
• Creates stagflation risk—the economy experiences both inflation and reduced output, a policy nightmare

Supply Shocks

• Sudden, unexpected disruptions to production capacity—think oil embargoes, natural disasters, pandemics, or geopolitical conflicts
• Shifts SRAS left abruptly, causing rapid price increases and output declines simultaneously
• The 1970s oil shocks are the classic AP example—OPEC's production cuts caused cost-push inflation across Western economies

Wage-Price Spiral

• Self-reinforcing cycle where higher wages increase production costs, leading firms to raise prices, prompting workers to demand higher wages again
• Represents built-in inflation becoming embedded in the economy's expectations and contracts
• Difficult to break without policy intervention—often requires contractionary policy that causes short-term unemployment

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Monetary Causes: The Quantity Theory Connection

The quantity theory of money ($MV = PY$) explains why sustained inflation is fundamentally a monetary phenomenon. When money supply growth outpaces real output growth, the price level must rise.

Increase in Money Supply

• More money circulating in the economy increases aggregate demand as people have more to spend
• Quantity theory predicts that if velocity (V) and real output (Y) are stable, increases in money supply (M) directly raise the price level (P)
• Long-run monetary neutrality means money supply changes only affect nominal variables (prices) in the long run, not real output

Currency Devaluation

• Domestic currency loses value relative to foreign currencies—imports become more expensive while exports become cheaper
• Import price increases feed into domestic inflation as businesses pass higher costs to consumers
• Can trigger cost-push dynamics if the economy relies heavily on imported raw materials or intermediate goods

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Expectations and Self-Fulfilling Inflation

What people expect to happen often causes it to happen. Inflationary expectations shift the SRAS curve because workers and firms build anticipated price increases into wages and contracts.

Built-In Inflation (Expectations)

• Expected inflation becomes actual inflation when workers negotiate higher wages and firms set higher prices in anticipation of rising costs
• Shifts SRAS leftward as higher expected prices translate into higher production costs today
• Creates persistence in inflation—even after the original cause disappears, expectations can keep inflation elevated

Wage-Price Spiral (Expectations Component)

• Expectations fuel the spiral's momentum—if workers expect 5% inflation, they demand 5% wage increases, which raises costs and prices by roughly 5%
• Adaptive expectations mean people base future predictions on recent past inflation, making high inflation sticky
• Breaking expectations requires credible policy commitment—central banks must convince the public that inflation will fall

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Aggregate Supply Reductions: The Output Side

Any factor that reduces the economy's ability to produce goods shifts SRAS left. This is the supply-side mirror to demand-pull inflation—same price increase, opposite output effect.

Decrease in Aggregate Supply

• Overall productive capacity declines due to natural disasters, regulatory burdens, resource depletion, or infrastructure failures
• SRAS shifts left, raising prices while reducing real GDP—the definition of stagflation
• Policy response is tricky—stimulating demand worsens inflation, while fighting inflation worsens the output decline

Supply Shocks (Revisited)

• Negative supply shocks are asymmetric—they hit suddenly and hard, while recovery is often slow
• Examples include oil price spikes, pandemic disruptions, and trade wars that restrict access to inputs
• Distinguish from demand shocks on exams—supply shocks move price level and output in opposite directions

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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? Explain how their transmission mechanisms differ.

2. If an economy experiences rising prices AND falling real GDP simultaneously, which type of inflation is occurring? Name two specific causes that could produce this outcome.

3. Compare and contrast demand-pull inflation and cost-push inflation: How do they differ in terms of which curve shifts, what happens to output, and what policy dilemma each creates?

4. Using the quantity theory of money ($MV = PY$), explain why sustained inflation is considered a "monetary phenomenon." What must happen to M relative to Y for inflation to persist?

5. An FRQ describes workers negotiating higher wages because they expect 4% inflation next year, and firms raising prices to cover higher labor costs. Which cause of inflation is this, and how would you graph it in the AD-AS model?