 Ask
Dr. Econ
What are some of the factors that contribute to a rise in inflation?
(October 2002)
This is a great question! Inflation rates and speculation about future
inflation are mentioned so often in the media that it's important to know
some basics about inflation.
What is inflation?
Inflation is defined as a rise in the general price level. In other words,
prices of many goods and services such as housing, apparel, food, transportation,
and fuel must be increasing in order for inflation to occur in the overall
economy. If prices of just a few types of goods or services are rising,
there isn't necessarily inflation.
Inflation may be measured in several ways. The September
1999 Ask Dr. Econ question notes that inflation is commonly measured
by "either a Gross Domestic Product Deflator (GDP Deflator) or a
Consumer Price Index (CPI) indicator. The GDP Deflator is a broad index
of inflation in the economy; the CPI Index measures changes in the price
level of a broad basket of consumer products." Each month, the Bureau
of Labor Statistics (BLS) publishes a press release that reports recent
changes in the CPI by product category and for several large metropolitan
areas in the United States. Another measure of inflation is the Personal
Consumption Expenditure Chain Price Index or PCE Price Index. The PCE
price index is published by the Bureau of Economic Analysis and measures
inflation across the basket of goods purchased by households.
What causes inflation?
Economists distinguish between two types of inflation: Demand-Pull Inflation
and Cost-Push Inflation. Both types of inflation cause an increase in
the overall price level within an economy.
Demand-pull inflation occurs when aggregate demand for goods and services
in an economy rises more rapidly than an economy's productive capacity.
One potential shock to aggregate demand might come from a central bank
that rapidly increases the supply of money. See Chart 1 for an illustration
of what will likely happen as a result of this shock. The increase in
money in the economy will increase demand for goods and services from
D0 to D1. In the short run, businesses cannot significantly increase production
and supply (S) remains constant. The economy's equilibrium moves from
point A to point B and prices will tend to rise, resulting in inflation.
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Cost-push inflation, on the other hand, occurs when prices of production
process inputs increase. Rapid wage increases or rising raw material prices
are common causes of this type of inflation. The sharp rise in the price
of imported oil during the 1970s provides a typical example of cost-push
inflation (illustrated in Chart 2). Rising energy prices caused the cost
of producing and transporting goods to rise. Higher production costs led
to a decrease in aggregate supply (from S0 to S1) and an increase in the
overall price level because the equilibrium point moved from point Z to
point Y.
While the differences in inflation noted above may seem simple, the cause
of price level changes observed in the real economy are often much more
complex. In a dynamic economy it can be especially difficult to isolate
a single cause of a change in the price level. However, knowing what inflation
is and what conditions might cause it is a great start!
Further Reading:
Parry, Robert T. "Issues
in the Inflation Outlook." FRBSF Weekly Letter 96-09,
Federal Reserve Bank of San Francisco. 1 Mar 1996.
Lansing, Kevin J. "Exploring
the Causes of the Great Inflation" FRBSF Economic Letter
2000-21, Federal Reserve Bank of San Francisco. 7 July 2000.
Bryan, Michael F. "Is
it More Expensive or Does it Just Cost More?" 2002 Economic
Commentary, Federal Reserve Bank of Cleveland. 15 May 2002.
Gavin, William T. and Rachel J. Mandal. "Predicting
Inflation: Food for Thought." The Regional Economist Federal
Reserve Bank of Saint Louis. January 2002.
Notes:
The calendar of upcoming
CPI release dates is available from the BLS:
Resources
Baumol, William J. and Alan S. Blinder. Economics; Principles and Policy.
1988. Harcourt Brace Jovanovich, Publishers. San Diego.
McConnell, Campbell R. and Stanley L. Brue. Economics.
1996. McGraw-Hill, Inc. New York.
Sameulson, Paul A. and William D. Nordhaus. Economics.
1998. Irwin McGraw-Hill. Boston.
Bureau of Economic Analysis
(BEA).
Bureau of Labor Statistics
(BLS).
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