2.1.1 - Causes and consequences of inflation

Demand-pull and cost-push inflation

Inflation can begin with stronger spending or with higher production costs, and these starting points can have different effects on output.

Demand-pull inflation arises when total demand grows faster than the economy can supply goods and services. Consumers may buy more, businesses may invest more, or export orders may rise. With spare workers and machines, firms can initially expand production. Close to capacity, extra orders are harder to meet, allowing firms to raise selling prices and competing employers to bid up wages. Increased spending is therefore more inflationary when supply cannot respond quickly.

Cost-push inflation arises when higher production costs push up prices across the economy. More expensive fuel, imported materials or wages not matched by productivity raise costs per unit. Firms may pass costs to customers to protect margins. If customers will not pay the higher prices, some firms instead accept lower profits or cut production. A rise in one small product's cost need not generate general inflation; energy can matter widely because many industries use it.

For example, crowded restaurants raising prices after a surge in bookings illustrate demand pressure. Restaurants raising prices because gas and food ingredients cost more illustrate cost pressure. Both can occur together. Falling demand does not instantly reverse an energy-price shock, and not every cost increase is fully passed on to consumers.

Low, stable inflation reduces uncertainty about these changing prices. High or unpredictable inflation makes it harder to tell whether a particular product has become more expensive relative to others or whether money prices generally are increasing.

Inflation and interest rates

Interest rates affect spending incentives, while inflation influences decisions about the rate of interest.

An interest rate is the cost of borrowing or reward for saving expressed as a percentage. Higher interest rates make new borrowing for purchases and investment more expensive. Some borrowers also face higher repayments, leaving less income for other spending. Saving becomes more attractive. These channels can reduce demand growth and ease demand-pull inflation. Lower rates tend to encourage spending and can increase inflationary pressure when capacity is limited.

A central bank may raise interest rates when it expects inflation to be persistently too high. This is a policy response to inflation, not proof that rising interest rates originally caused it. The effect takes time as loans, savings and spending decisions adjust. Higher interest rates do not themselves produce more fuel or remove a supply shortage. They may nevertheless restrain wider spending and prevent an initial cost rise leading to continuing general price pressure, with a possible cost in output and jobs.

Inflation also affects the purchasing power of savings and loan repayments. A saver receiving interest below the inflation rate can buy less with the savings even though the money balance increases. Unexpected inflation reduces the real value of a fixed money debt, benefiting the borrower at the lender's expense. Lenders may seek higher nominal interest to compensate for expected inflation. The actual relationship is therefore not a rule that every interest-rate movement immediately produces the opposite movement in inflation.

Prices, wages, exports and jobs

Inflation changes real purchasing power and competitiveness, while its cause helps determine what happens to unemployment.

The general price level rises during inflation, but individual prices change at different rates. Households with unchanged money incomes buy less. Nominal wages may rise as workers seek compensation, yet real wages fall if pay grows more slowly than prices. If wages rise faster than prices, real wages can rise. Workers with stronger bargaining power may protect their purchasing power more successfully than workers on fixed pay, so the effects are uneven.