Primary Causes of Inflation & Deflation

As the war in Ukraine drags on, the physical devastation and impact of sanctions continue to shake the global economy. The impact will be higher energy prices and weaker confidence in the economy and financial markets in a world already suffering from pandemic-related inflation. Corrado and colleagues from the National Institute of Economic and Social Research have quantified the transmission channels of wars in our latest Global Economic Outlook. Russia and Ukraine are major suppliers of certain commodities, including titanium, palladium, wheat and corn. The impact of the wars on commodity prices and inflation, and hence on household spending, is more important than possible contagion from trade links with other nations [1]

The Meaning of Inflation

High inflation is one of the most common phenomena that every country must deal with, at least a time in its economic history. In a market economy, the prices of goods and services can change constantly. Some prices go up; some prices fall. Inflation occurs when the prices of goods and services increase across the board, not just individual items; That means you can buy less for 1 today than yesterday. In other words, inflation decreases the value of the currency and shrinks the real wages over time. When calculating the average price increase, the prices of products on which we spend more, such as electricity, are weighted more heavily than the prices of products on which we spend less, such as sugar or postage. Let RW = Real Wage, NW = Nominal Wage and Ir = Inflation Rate.

RW = NW - NW * Ir

RW = (1 - Ir)*NW

According to the European Central Bank (ECB), in the euro area, consumer price inflation is measured using the Harmonised Index of Consumer Prices (HICP). The term harmonised means that all European Union countries use the same methodology. This ensures that data from one country can be compared to data from another country. This metric is a good way to track how prices are changing in the economy. The main goal of the ECB is to ensure price stability. A very interesting service that can use everybody free is Personal Inflation Calculator, which determines the personal inflation rate based on the consumption habits.

Different Types of Inflation

It is important to note that there are many types of inflation. These types of inflation are differentiated from each other by the cause that drives the price increase. Inflation is sometimes classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation. Built-in inflation is an alternative explanation for rising prices that differs from cost-push and demand-pull theories, which highlights the role of expectations for future inflation by consumers and businesses [2][5].

Demand-Pull

"Too many dollars chasing too few goods" is a condition that economists describe as demand-pull inflation. " This type of inflation can be caused by an increase in aggregate demand. Keynesian economics suggests that an increase in aggregate demand may be caused by a rise in employment. Higher wages translate into greater demand in a tight labor market. The term demand-pull inflation usually describes a widespread phenomenon. That is, when consumer demand outpaces the available supply of many types of consumer goods, demand-pull inflation sets in, forcing an overall increase in the cost of living.

Demand-pull inflation is a principle of Keynesian economics that describes the effects of an imbalance between supply and demand. When aggregate demand in an economy greatly exceeds aggregate supply, prices rise. This is the most common cause of inflation. In Keynesian economic theory, an increase in employment leads to an increase in aggregate demand for consumer goods. In response to demand, companies are hiring more workers to increase production. The more people hire companies, the more employment increases. After all, the demand for consumer goods exceeds the ability of manufacturers to supply them. There are five main causes of demand-pull inflation [3]:

• Growing Economy: When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.
• Increasing Export Demand: A sudden rise in exports forces an undervaluation of the currencies involved.
• Government Spending: When the government spends more freely, prices go up.
• Inflation Expectations: Companies may increase their prices in expectation of inflation in the near future.
• More Money in the System: An expansion of the money supply with too few goods to buy makes prices increase.

Cost-Push

Cost push inflation (also known as wage push inflation) occurs when overall prices rise due to increases in labor and commodity costs (inflation). Higher production costs can reduce the total supply (the amount of total production) in the economy. Since demand for goods has not changed, price increases are passed from production to consumers, leading to cost inflation.

The most common cause of cost-push inflation starts with an increase in production costs, which can be expected or unexpected. For example, the cost of raw materials or inventory used in production could increase, leading to higher costs. For cost-push inflation to occur, demand for the affected product must remain constant during the time that the cost of production changes occur. To offset the increased cost of production, manufacturers raise the price to the consumer to maintain profit levels while keeping up with expected demand. There are four main causes of cost-push inflation [4]:

• Cost of Input GoodsAs previously mentioned, an increase in the cost of inputs used in manufacturing, such as raw materials. For example, if companies use copper in the manufacturing process and the price of the metal suddenly increases, companies can pass these increased costs on to their customers.
• Increased labor costs: mandatory wage increases for production employees due to an increase in the minimum wage per worker.
• Natural Disasters: When a major disaster causes unexpected damage to a production facility and leads to a standstill or partial disruption of the production chain, higher production costs are likely to result.
• Government Policy: Other events could qualify if they result in higher production costs, such as: a sudden change in government laws affecting the country's ability to maintain its previous production. However, state-related increases in production costs are more common in developing countries.

Built-In

When demand-pull inflation and cost-push inflation occur, workers can start asking employers for a raise. If employers don't keep their wages competitive, they could end up with a labor shortage. When a company raises workers' wages or salaries and tries to maintain profit margins by raising prices, it is built-in inflation. For example, if you find out that your favorite coffee house is raising prices due to the rising cost of coffee beans, you are a victim of cost-push inflation. And if you buy that coffee when the price is uncomfortably high, you get into demand-pull inflation.

In other words, built-in inflation is related to adaptive expectations, or the notion that people expect current inflation rates to persist in the future. As the prices of goods and services increase, people can expect continuous increases of a similar magnitude in the future. Therefore, workers may demand more costs or wages to maintain their standard of living. Their higher wages translate into higher costs for goods and services, and this wage-price spiral continues as one factor induces the other and vice versa [5].

The Impact of Deflation

Most economists today believe that low, stable and above all predictable inflation is good for an economy. When inflation is low and predictable, it is easier to capture in price adjustment contracts and interest rates, reducing its distorting effect. Additionally, knowing that prices will be slightly higher in the future gives consumers an incentive to shop earlier, which boosts economic activity. Many central bankers have made maintaining low and stable inflation a priority policy objective, a policy known as inflation targeting [6].

The exact opposite of inflation is deflation. When there is deflation, the prices of goods and services fall, which in turn increases the purchasing power of money. It also means that more goods and services can be bought with the same amount of money. This situation occurs naturally in an economy when the money supply of an economy is constrained. Deflation is generally viewed as an economic crisis associated with unemployment and very low levels of productivity of goods and services. Some of the main problems of Deflation are [8][10]:

• Discourages consumer spending: When prices fall, this often tempts people to delay buying because they will be cheaper in the future. This decline in consumer spending was a feature of Japan's deflationary experience in the 1990s and 2000s. (Japanese Financial Crisis / Lost Decades).
• Increase Real Value of Debt: Deflation increases the real value of money and the real value of debt. Deflation makes it harder for debtors to pay their debts. In a period of deflation, businesses will also see lower revenues and consumers are likely to receive lower wages.
• Increased Real Interest Rates: Interest rates cannot go below zero. Therefore, deflation can contribute to an unwanted tightening of monetary policy. This is particularly a problem for eurozone countries that do not use other monetary policies such as quantitative easing. This is another factor that can lead to lower growth and higher unemployment.
• Real Wage Unemployment: Labor markets frequently display "sticky wages." Workers in particular oppose nominal salary reductions because no one likes to really see their pay decrease, especially when they're used to annual pay rises. Real wages, therefore, increase during deflationary periods. It might result in real-wage unemployment. Low inflation is one of the primary factors contributing to Europe's high unemployment rate.
In a deflationary situation, businesses and the general public accumulate less wealth and therefore spending becomes very low, further reducing demand [7]Former Fed Chairman Paul Volcker proved this in the 1980s. He fought double-digit inflation by raising interest rates to 20% [9]. He kept it there even though it caused a recession. He had to take this drastic action to convince everyone that inflation could actually be tamed. Thanks to Volcker, central bankers now know the most important tool in combating inflation or deflation is controlling people's expectations of price changes.

References

1. Macchiarelli, Corrado.  "Russia’s War in Ukraine Is Driving Global Inflation. Here’s How Much." Barrons, Jul 8, 2022, barrons.com/articles/war-in-ukraine-driving-global-inflation-51657294183
2. Moffatt, Mike. "Inflation in Economics." ThoughtCo, Feb. 16, 2021, thoughtco.com/study-overview-of-inflation-1147538
3. James, Chen. "What is Demand-Pull Inflation?" Investopedia, Sep. 14, 2022, investopedia.com/terms/d/demandpullinflation.asp
4. Will, Kenton. "Cost-Push Inflation: When It Occurs, Definition, and Causes" Investopedia, Mar. 07, 2022,  investopedia.com/terms/c/costpushinflation.asp
5. Geoff, Williams. "3 Types Of Inflation And How They Differ" Forbes Advisor, Jul. 27, 2022, forbes.com/advisor/personal-finance/types-of-inflation/
6. Jason, Fernado. "Inflation: What It Is, How It Can Be Controlled, and Extreme Examples" Investopedia, Sep. 13, 2022, investopedia.com/terms/i/inflation.asp
7. Maheshwari, Rashi. "Inflation And Deflation" Forbes Advisor, Oct 10, 2022, forbes.com/advisor/in/investing/inflation-and-deflation/
8. Wessel, David. "Five Reasons to Worry About Deflation" Brookings, Oct. 16, 2014, brookings.edu/opinions/5-reasons-to-worry-about-deflation/
9. Federal Reserve Bank of New York. “Historical Changes of the Target Federal Funds and Discount Rates.
10. Tejvan, Pettinger. "Problems of deflation" Economics Help, Dec. 09, 2019, economicshelp.org/blog/978/economics/definition-of-deflation/

Stefanos Stavrianos is senior graduate student in the School of Applied Economics & Social Sciences (A.U.A) and has a Quantitative Finance Specialization (H.S.E). His research interests focus on Political Economy, Advanced Microeconomics, Microfoundations in Macroeconomics, Production Economics, International Trade, Development Economics, Industrial Organization and Mathematical Economics.