What is causing inflation?

What is causing inflation? Supply chain issues, surging demand, production costs, and swaths of relief funds all have a role to play.

We have witnessed a sudden and severe rise in US inflation. Prices at the pump have soared. Goods from hammocks to hand sanitizer have jumped in price.

What is going on? Can we delve deeply into how inflation works?

Nobel Prize Winning Economist & Stanford Professor Paul Romer on Hyperinflation & Protecting Science

Inflation is defined as a sustained increase in the general price levels of an economy. If the country’s target inflation rate of 2% is crossed. The Federal Reserve (the central bank of USA) may need to adopt a contractionary monetary policy, which it has by raising interest rates.

According to economist Michael Feroli, huge price increases in “import-dependent categories. Such as information-technology” contributed largely to the rise in inflation. 

Image result for demand pull inflation

Diagram 1: The US economy : What is causing inflation?

Diagram 1 shows the rightward shift (indicated by red arrows) of the Aggregate Demand curve. From AD1 to AD2 due to a rise in consumer spending on domestic goods. And a decrease in the level of imports in USA. Even though the shift leads to the real GDP increasing from YP to Yinfl. It causes a rise in US inflation by increasing average price levels from Pl1 to Pl2 by 0.6% in two months. Moreover, the tariffs on solar panels imported from China have increased the costs of production for US real-estate companies that use renewable resources. This, along with other tariffs, have led to these firms lowering production of goods. Thus contributing to cost-push inflation in USA.  

Image result for business cycle with no labels

Diagram 2: The business cycle of US economy : What is causing inflation?

Diagram 2 depicts the business cycle of the US economy. It displays points A (trough), B (Expansion), C (Peak) and D (Contraction) on the real GDP curve. The US economy was at point X in May 2019 as it was experiencing disinflation. However, due to the sudden rise in inflation, the economy reached point Y in July instead of Z, the expected location. This shows the limitation of economic theory in accurately representing reality, since theory predicts that disinflation directly leads to deflation.

The rising prices of basic commodities like food have decreased consumer purchasing power and have had a regressive effect on lower-income families in USA. Other effects include decreasing real-incomes, lowering business confidence due to uncertainty, and a rising burden on import-dependent industries due to the tariffs. All this has incentivised the Federal bank to consider contractionary demand-side policies, given that inflation eventually crosses the target 2%. 

Diagram 1 also indicates how increasing the interest rates of borrowing money.

As a result of lowering the supply of money in the US economy causes the rate of inflation to decrease. Interest rates are defined as the cost of borrowing and reward for saving money. The Aggregate Demand curve shifts leftwards (indicated by green arrows). From AD2 to AD1 due to a decrease in firm investments and consumer borrowing in USA. It causes the average price levels to decrease from Pl2 to Pl1. The consumer purchasing power to increase in the short run, and the burden on lower-income families to lessen in the long run. 

This contractionary policy may seem effective at curing the increasing inflation, but it does have several drawbacks. Firstly, it leads to an economic contraction by decreasing real GDP and increasing unemployment, thus compromising two macroeconomic objectives in pursuit of one.

Moreover, even though the purchasing power of US consumers increases. With lowering prices, those who depend on loans from banks will suffer. Even the situation of bankrupting firms may exacerbate with higher costs of borrowing. 

Furthermore, it is unlikely that this monetary policy will be able to cure inflation and bring satisfaction to stakeholders immediately due to the time lags in implementation. The Federal Bank takes time (usually 18 months) to recognise problems, come to a decision and eventually implement the policy. Lastly, most policy makers tend to assume that people will behave the way economic theory predicts.

But this may not be the case in real life, as, for example. Some consumers and businesses may still want to borrow and spend despite the interest rate increase. Also, this monetary policy cannot deal with cost-push inflation as it cannot lower inflation and cause economic growth at the same time. 

Instead, the US government can employ interventionist supply-side policies, such as increasing investments in technology. Alongside the Federal bank’s monetary policy in order to deal with the stagflation caused by tariffs. Even though there’s a slightly higher time lag associated with this policy. And it entails a burden on the government budget, it can guarantee simultaneous economic growth, lower unemployment and decreased inflation.

Of course, the global supply glut has resulted in huge price increases in almost every consumer product.

What is causing inflation?

Rebellion Research