Is there a cause for inflation? It comes down to a mix of output, money, and expectations. Higher prices can be caused by supply shocks. Increasing the money supply can cause prices to go up. As workers demand higher wages and companies raise prices, the expectation of inflation becomes a self-fulfilling prophecy.
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Since the financial crisis of 2008 and the Great Recession, investors and executives have grown used to low interest rates and low inflation. It's no longer possible. The U.S. saw its worst inflation in decades in 2022.
A good reason to understand what causes inflation and how to manage this gradual loss of purchasing power is what the International Monetary Fund warned about in October.
Inflation is defined as a rise in prices across an economy and it has become one of the biggest threats to global prosperity.
Money doesn't go as far as it used to, which can cause demand for raises, which can cause more inflation. The basic functioning of an economy can be broken down when prices rise fast. In periods of hyperinflation, people rush to spend money the moment they get paid, because every hour they wait to spend increases the price.
Central banks usually set an inflation target and use interest rates to make sure prices don't go up too fast. A small amount of inflation is usually harmless. 2% increase in prices is the goal of the U.S. Fed.
In the US and much of the world, prices have risen more quickly than in the US. High inflation has caused many central banks to raise interest rates, which could slow global growth and even cause a recession. It is helpful to start with the basics of inflation and what causes it.
Inflation is caused by too much demand and not enough supply. When the aggregate quantity of goods demanded at any particular price level is rising more quickly than the aggregate quality of goods supplied at that price level, inflation occurs.
What causes demand to go up? It's important to understand that there are three pillars of macroeconomics that David Moss describes in his book A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to know. Moss takes output, money, and expectations into account when structuring the book. The three are involved in inflation.
Major disruptions to an important economic input, like energy, can cause supply shocks and lead to inflation. If a lot of oil fields stop producing oil, the price of energy goes up. Since energy is a critical part of almost every other good, prices of other things also go up. This is referred to as cost push inflation.
A decrease in the supply of a good should lead to a higher price and a new equilibrium. Things are more complex in practice. A supply shock could cause a sustained increase in prices because there aren't many good alternatives. There is uncertainty about when the supply shock will end or if the initial price increase will change peoples' expectations about future inflation.
There is money supply and demand. Moss says that an increase in the money supply will cause inflation. Consumers often find new reasons to buy things with more cash in their pockets and bank accounts. Consumers will bid up prices if the supply of goods and services does not increase. Inflation can rise when too much money is chasing too few things. It is sometimes referred to as demand- pull inflation.
According to the money supply theory of inflation, it's always and everywhere a monetary phenomena. Friedman claimed that increases in the money supply could cause inflation. Expectations could be the cause of inflation if you had to boil it down.
The cause of inflation is not an increase in the money supply but an unforeseen increase in the money supply. If everyone knows demand will increase, then supply will increase as well. The increase in demand is the cause of inflation.
How much inflation people expect is related to how much inflation we get. Workers can't buy as much with their wages as the prices of goods go up. People will bargain for higher wages if they expect inflation to go up. Businesses can cause a wage-price spiral if they expect wage inflation. Wage-price spirals are not very common.
Central banks try to keep inflation expectations anchored because expectations matter so much. They want to convince everyone that they will be able to meet their inflation target, so that they don't worry about month-to-month inflation data, and just assume that inflation will rise by whatever the central bank says.
The root of inflation is demand. One way to think about the idea is to ask how much slack there is in the economy. The economy uses people's time and ingenuity, machines and other infrastructure. In the wake of the 2008 financial crisis, many countries experienced high unemployment. Lots of economic resources weren't being put to use.
There is little risk of inflation in an economy with a lot of slack. Unemployed workers would be hired, factories would reopen, and more would be produced if demand suddenly increased. Inflation occurs when an economy is operating very close to its full potential. Inflation is more common when there is unemployment. Workers with jobs can demand higher wages which can increase prices. There aren't many workers available to deal with extra demand You get too much money when you chase too few things.
Inflation is not caused by low unemployment. There is a tradeoff between low inflation and low unemployment when the economy is full.
Demand and inflation are controlled by central banks. They increase their target for short-term interest rates if inflation is high. Borrowing costs are less attractive for firms and consumers because of higher interest rates. Lower demand to bring it in line with supply relieves the pressures that were raising prices.
Open market operations are the main way in which central banks affect interest rates in the U.S. The Fed buys and sells bonds and other assets in order to affect the money supply and the short-term interest rate.
There are many different measures of inflation that try to track changes in the price levels of goods. The consumer price index is one of the most cited. The average price of a basket of goods that households buy is tracked by the Consumer Price index. The prices that households have to pay have gone up.
The coreCPI is the one that excludes food and energy prices. The prices of those two categories change a lot from month to month. It is easier to see if the economy is experiencing an increase in prices if you look at the average price level.
The producer price index is a measure of the price businesses pay for inputs and the personal consumption expenditure index is a measure of consumer prices.
The past year and a half has seen high inflation due to both supply and demand side factors. There were shipping snarls, worker shortages, and spikes in energy and food prices caused by the invasion of Ukraine. The price of a lot of goods suddenly went up because of the cost of energy and transportation.
Many countries funneled large sums of money to households and companies during the Pandemic to make sure they were able to manage their businesses. Inflation may have been caused by that increase in the money supply. Consumers had money in their pockets and couldn't spend it on restaurants so demand for physical goods increased.
Some people don't know how much these factors contributed. The New York Federal Reserve estimated that 40% of the rise in prices in 2021 was due to supply side factors.
No one knows for certain. Here are some predictions as of this writing.
Good management doesn't affect inflation. There are a few things managers need to think about. How to handle rising prices is the first thing. The University of Minnesota has a few different strategies to consider. To make sure you have a policy in place for when and how you change your prices, is the most basic thing you can do. Menu costs can add up to a lot of money.
There are suggestions for managing through inflation in this HBR piece. One of them is to communicate more with employees in order to keep them happy. Since funding can be higher due to rising interest rates, it can be difficult to retain employees when the labor market is tight. A Harvard Business School lecturer and former tech CEO recommends that you focus on your company culture and prioritize the employees you need to retain.
You have to have a plan for managing through the cure as well. Companies need to assess their strategies and operations in light of inflation fighting by central banks. Higher interest rates tend to shift investors' interest towards short-term profits.
Econofact has an article on why inflation is increasing.
There is a primer on inflation in the US.
David Moss wrote a guide to macro economics.
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