Understanding Inflation: Types and Causes | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Welcome back as we study the types of inflation and its causes. We shall learn what is cost-push inflation, and demand-pull inflation.

Inflation Basics

Inflation is a sustained increase in the overall price level over time. If inflation is present in an economy, the prices of almost all goods and services are increasing. Inflation erodes the purchasing power of a currency, meaning that the same dollar can buy fewer goods over time. As such, inflation favors borrowers at the expense of lenders, because when the borrower returns the principal to the lender, the purchasing power of that amount is lower than it was when it was borrowed.

The inflation rate is the percentage increase in the price level, typically compared to the prior year. In general, the inflation rate is pro-cyclical, that is it goes up and down with the business cycle, but with a lag of a year or more.

Disinflation refers to an inflation rate that is decreasing over time but remains greater than zero.

Deflation is the phenomenon where the inflation rate is persistently negative over a period of time. Deflation is commonly associated with deep recessions, and is a scenario that central banks want to avoid at all cost as it is difficult to bring an economy out of deflation. This is because when most prices are decreasing, consumers delay purchases because they believe they can buy the same goods more cheaply in the future. This depresses aggregate demand, causing prices to further decline in a downward spiral.

At the other extreme, inflation that accelerates out of control is referred to as hyperinflation, which can destroy a country’s monetary system and bring about social and political upheavals.

To prevent either scenario from happening, central banks tend to closely monitor the inflation rate and take monetary actions to keep it within a target range. Contractionary monetary policies, like increasing the benchmark interest rate, are used when inflation is too high, and expansionary policies are used when the inflation rate is too low. As such, analysts and investors often monitor inflation rate to anticipate the central bank’s monetary policy, which can have a profound effect on asset prices.

Cost-Push Inflation

Inflation can be a result of cost pressures, or demand pressures. We’ve gone through this before in the lesson on macroeconomic equilibrium, so we’ll briefly touch on it here.

When the cost of an important factor of production, such as labor or energy, increases, the short-run aggregate supply curve of the economy is shifted to the left. At the new short-run equilibrium, output is lower, but price is higher. If the central bank opts to stimulate aggregate demand so output returns to its long-run potential, the result would be a further increase in the price level. This is known as cost-push inflation because it is brought about by an increase in costs of production to the producers.

The most prevalent source of cost-push inflation is the pressures caused by an increase in wages. Analysts have several ways to study wage pressures. The most straightforward is to look at the unemployment rate. The lower the unemployment rate, the higher the pressure on wages.

However, most analysts acknowledge that the unemployment rate may not be the most effective indicator of wage pressures. Factors such as jobs-skills mismatch, cultural patterns that despise certain jobs, and inefficiencies in the labor market can mean the economy is facing labor shortages even though the unemployment rate is not that low.

A better indicator that encompasses these aspects of the labor market is the non-accelerating inflation rate of unemployment (NAIRU), or the natural rate of unemployment (NARU). You do not need to know how they are determined, but just to be aware that they can be better indicators of wage pressures which is a major factor of cost-push inflation.

Besides NAIRU or NARU, analysts can use data on labor productivity to identify signs of potential wage pressure. Wage increases are not inflationary as long as they remain in line with gains in productivity. A useful indicator of wages and benefits in terms of productivity is unit labor costs, the ratio of total labor compensation per hour, to output units per hour.

An additional source of wage pressure is expected inflation. If workers expect inflation to increase, they will increase their wage demands accordingly. One indicator analysts use to gauge expected inflation is the difference in yield between inflation-indexed bonds, such as Treasury Inflation-Protected Securities, and otherwise similar non-indexed bonds.

Demand-Pull Inflation

When prices rise as a result of demand pressures, it is called demand-pull inflation. The increased demand is usually a result of an increase in the money supply, or increased government spending. When this happens, the aggregate demand curve shifts to the right. At this new short-run equilibrium, both the output and price levels are higher.

With real GDP above its full-employment level, the increase in GDP is not sustainable. Unemployment falls below its natural rate, which puts upward pressure on real wages and input prices. Rising cost of production results in a decrease in short-run aggregate supply, until real GDP reverts back to full-employment GDP. Although output falls back to full-employment GDP, the price level is now even higher!

However, if the central bank continues to increase the rate of money supply, this cycle is set to continue, raising price levels in an upward spiral.

To measure the potential for demand-pull inflation in an economy, economists often study the capacity utilization rate of key industries. High rates of capacity utilization suggest that the economy is producing above potential GDP, and may experience inflationary pressure.

The key difference between demand-pull and cost-push effects is the impact on output. The demand-pull effect increases GDP above full-employment GDP, while the cost-push effect decreases GDP, resulting in higher short-term unemployment.

Conclusion

And that concludes this lesson where we learned the types and causes of inflation. In our next lesson, we shall learn how price levels are measured.