Inflation

Definition:

Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

A similar definition of inflation can be found in Economics by Parkin and Bade:

Inflation is an upward movement in the average level of prices. Its opposite is deflation, a downward movement in the average level of prices. The boundary between inflation and deflation is price stability.

The Link Between Inflation and Money

Because inflation is a rise in the general level of prices, it is intrinsically linked to money, as captured by the often heard refrain "Inflation is too many dollars chasing too few goods". To understand how this works, imagine a world that only has two commodities: Oranges picked from orange trees, and paper money printed by the government. In a year where there is a drought and oranges are scarce, we'd expect to see the price of oranges rise, as there will be quite a few dollars chasing very few oranges. Conversely, if there's a record crop or oranges, we'd expect to see the price of oranges fall, as orange sellers will need to reduce their prices in order to clear their inventory. These scenarios are inflation and deflation, respectively, though in the real world inflation and deflation are changes in the average price of all goods and services, not just one.

Inflation and the Money Supply

We can also have inflation and deflation by changing the amount of money in the system. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, just as in our drought situation. Thus inflation is caused by the amount of dollars rising relative to the amount of oranges (goods and services), and deflation is caused by the amount of dollars falling relative to the amount of oranges. Thus, as shown by the article "Why Does Money Have Value?", inflation is caused by a combination of four factors:

1. The supply of money goes up.
2. The supply of other goods goes down.
3. Demand for money goes down.
4. Demand for other goods goes up.

What do the terms "Cost-Push Inflation" and "Demand-Pull Inflation" mean? What's the difference between the two.

The terms cost-push inflation and demand-pull inflation are associated with Keynesian Economics. Without going into a primer on Keynesian Economics we can still understand the difference between two terms.

We've seen that inflation is caused by a combination of four factors. Those factors are:

• The supply of money goes up.
• The supply of goods goes down.
• Demand for money goes down.
• Demand for goods goes up.

Let's look at the definition of cost-push and demand-pull inflation and see if we can understand them using our four factors.

Definition of Cost-Push Inflation

The text "Economics" (2nd Edition) by Parkin and Bade gives the following explanation for cost-push inflation:

"Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are

• An increase in wage rates
• An increase in the prices of raw materials

These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation

Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production." (pg. 865)

Aggregate supply is the "the total value of the goods and services produced in a country" or simply factor 2, "The supply of goods". The supply of goods can be influenced by factors other than an increase in the price of inputs (say a natural disaster), so not all factor 2 inflation is cost-push inflation.

Of course, the next question would be "What caused the price of inputs to rise?". Any combinations of the four factors could cause that, but the two most likely are factor 2 (Raw materials such as oil have become more scarce), or factor 4 (The demand for raw materials and labor have risen).

Definition of Demand-Pull Inflation

Parkin and Bade give the following explanation for demand-pull inflation:

"The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such an inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are

1. Increases in the money supply
2. Increases in government purchases
3. Increases in the price level in the rest of the world

Inflation caused by an increase in aggregate demand, is inflation caused by factor 4 (An increase in the demand for goods). The three most likely causes of an increase in aggregate demand will also tend to increase inflation:

1. Increases in the money supply This is simply factor 1 inflation.

2. Increases in government purchases The increased demand for goods by the government causes factor 4 inflation.

3. Increases in the price level in the rest of the world Suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see less Americans buy gum from Canadians and more Canadians purchase the cheaper gum from American sources. From the American perspective the demand for gum has risen causing a price rise in gum; a factor 4 inflation.

Inflation in Summary

Cost-push inflation and demand-pull inflation can be explained using our four inflation factors. Cost-push inflation is inflation caused by rising prices of inputs that causes factor 2 (The supply of goods goes down) inflation. Demand-pull inflation is factor 4 inflation (The demand for goods goes up) which can have many causes.