What Causes Inflation? These Are the Two Most Notable Theories

Inflation can be caused by a number of factors, read on to find out more!

• Inflation is a rise in the general price level of goods and services in an economy. We haven't seen much high inflation in recent decades, but we are now!. Still, when it appears, the effects can be devastating.
• Inflation is most commonly measured by the increase in the Consumer Price Index (CPI). But it would be better to think of it as a decrease in the amount of stuff you can buy with your money. 
• Numerous theories exist about the cause of inflation. The most notable theories of inflation come from the Keynesian and Monetarist economic schools of thought.

Inflation can be defined as the rise in the general price level of goods and services in an economy.

High levels of inflation can have severe consequences. With inflation, your money’s purchasing power decreases, meaning it’s worth less. It has been proven that excessive inflation levels are harmful to long-run economic growth on a macro level. 

What Causes Inflation?

Well, in a way, no one knows for sure... or at least, not everyone can agree on the reasons! Numerous theories exist about the cause of inflation. The most notable theories of inflation come from the Keynesian and Monetarist schools of thought.

1) Keynesianism

“Too many dollars chasing too few goods.”

Founded by British economist John Maynard Keynes, the Keynesian school of thought theorised that inflation is a consequence of economic pressures. The Keynesian school of thought differentiates between two main types of inflation: 

Cost-push inflation

This results from increased production costs, e.g. rent, wage levels, and raw materials. Producers respond to the rise in their production costs by increasing the price of their product(s), meaning the increased production costs are passed on to consumers.

Demand-pull inflation

This is a result of excessive aggregate demand relative to aggregate supply (both defined below). In other words, there is a supply shortage, resulting in price increases.

Aggregate demand = a measurement of total demand for all completed goods and services created in an economy.

Aggregate supply = a measurement of the total supply of all completed goods and services produced in an economy.

Essentially, this school of thought believes that the control of inflation is through government intervention, e.g. raising or lowering taxes and raising or lowering government spending.

2) Monetarism

"Inflation Is Always and Everywhere a Monetary Phenomenon"

Monetarists do not subscribe to the view that the solution to inflation is government intervention. They believe that an excessive expansion of the money supply causes inflation and that inflation can be controlled by stable growth of the money supply in line with Gross Domestic Product (GDP).

GDP = the value of all finished goods and services made within a country during a specific period.

For Monetarists, the control of inflation would be a job for central banks who would limit or expand the money supply in the economy relative to overall GDP growth.

THE CAUSES OF INFLATION. COMPLETED. ✅

Sources:

1. https://www.vox.com/2014/7/24/18080392/inflation-definition-and-explanation
   
2. https://www.investopedia.com/articles/personal-finance/073015/understand-different-types-inflation.asp 
3. Header photo from Unsplash