What creates inflation?
Long-lasting episodes of high inflation are often the result of lax monetary
policy. If the money supply grows too big relative to the size of an economy,
the unit value of the currency diminishes; in other words, its purchasing power
falls and prices rise. This relationship between the money supply and the size
of the economy is called thequantity theory of moneyand is one of the oldest
hypotheses in economics.
Pressures on the supply or demand side of the economy can also be
inflationary.Supply shocksthat disrupt production, such as natural disasters,
or raise production costs, such as high oil prices, can reduce overall supply
and lead to “cost-push” inflation, in which the impetus for price increases
comes from a disruption to supply. The food and fuel inflation of 2008 was
such a case for the global economy—sharply rising food and fuel prices were
transmitted from country to country by trade. Conversely,demand shocks,
such as a stock market rally, orexpansionary policies, such as when a central
bank lowers interest rates or a government raises spending, can temporarily
boost overall demand and economic growth. If, however, this increase in
demand exceeds an economy’s production capacity, the resulting strain on
resources is reflected in “demand-pull” inflation. Policymakers must find the
right balance between boosting demand and growth when needed without
overstimulating the economy and causing inflation.
Expectationsalso play a key role in determining inflation. If people or firms
anticipate higher prices, they build these expectations into wage negotiations
and contractual price adjustments (such as automatic rent increases). This
behavior partly determines the next period’s inflation; once the contracts are
exercised and wages or prices rise as agreed, expectations become self-
fulfilling. And to the extent that people base their expectations on the recent
past, inflation would follow similar patterns over time, resulting in
inflationinertia.
