Causes of Inflation

October 13, 2010Inflationby EconomyWatch


A sustained rise in the prices of commodities that leads to a fall in the purchasing power of a nation is called inflation. Although inflation is part of the normal economic phenomena of any country, any increase in inflation above a predetermined level is a cause of concern.

High levels of inflation distort economic performance, making it mandatory to identify the causing factors. Several internal and external factors, such as the printing of more money by the government, a rise in production and labor costs, high lending levels, a drop in the exchange rate, increased taxes or wars, can cause inflation.

Different schools of thought provide different views on what actually causes inflation. However, there is a general agreement amongst economists that economic inflation may be caused by either an increase in the money supply or a decrease in the quantity of goods being supplied.The proponents of the Demand Pull theory attribute a rise in prices to an increase in demand in excess of the supplies available. An increase in the quantity of money in circulation relative to the ability of the economy to supply leads to increased demand, thereby fuelling prices. The case is of too much money chasing too few goods. An increase in demand could also be a result of declining interest rates, a cut in tax rates or increased consumer confidence.

The Cost Push theory, on the other hand, states that inflation occurs when the cost of producing rises and the increase is passed on to consumers. The cost of production can rise because of rising labor costs or when the producing firm is a monopoly or oligopoly and raises prices, cost of imported raw material rises due to exchange rate changes, and external factors, such as natural calamities or an increase in the economic power of a certain country.

An increase in indirect taxes can also lead to increased production costs. A classic example of cost-push or supply-shock inflation is the oil crisis that occurred in the 1970s, after the OPEC raised oil prices. The US saw double digit inflation levels during this period. Since oil is used in every industry, a sharp rise in the price of oil leads to an increase in the prices of all commodities.

While money growth is considered to be a principal long-term determinant of inflation, non-monetary sources, such as an increase in commodity prices, have played a key role in triggering inflation in the past four decades.

Inflation has become a major concern worldwide in 2008, with global prices rises in oil, food, steel and other commodities being the culprit.

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