Inflation

What Causes Inflation?

Many different factors may cause the price of a good to increase on a one-time basis: an increase in demand for that good, a reduction in supply (a bad harvest, for example, in the case of some farm produce), an increase in production costs (wages, raw materials, energy), an increase in taxes on that product, and so forth. But an increase that affects most, or nearly all, prices can only be caused by something that affects the entire economy, such as a general increase in [Page 1127]wages (above the increase in productivity) or in the price of oil and other imported raw materials (due, for example, to a depreciation of the currency) or in taxes on production or sales. Nevertheless, events such as these may explain one-time price increases, but not continued and sustained increases in the prices of large numbers of goods over an extended period.

There is a broad consensus among economists that inflation can only be caused by an excessive increase in the supply of money in a country over a period and that a continued, sustained, and excessive increase in the money supply may turn a one-time increase in a few prices into full-blown inflation. That is why inflation is often said to be a monetary phenomenon: too much money chasing too few goods. If a country's financial system creates more money—that is, more purchasing power—than the value of the goods available, there will be a “bidding war” among potential buyers. That leads to price increases, which are passed on from one market to another and persist over time.

Therefore, to understand inflation, we need to understand how the money is created and controlled, in other words, how monetary policy is designed and implemented. But if it is public knowledge that excessive growth of the money supply leads to inflation, why do governments and central banks promote it or allow it to happen? There are many reasons why they might do that: to stimulate demand and production, to avoid a recession due to cost increases, or as a consequence of mistakes or accidents. Whatever their motives, the monetary authorities choose a short-term advantage—often a political advantage, such as winning an election—at the cost of a longterm disadvantage—higher inflation.

Nevertheless, the most common cause of excessive growth in the money supply, leading to high inflation, tends to be the financing of the budget deficit: When a government spends above its means, it is tempted to ask the central bank for a loan, and that loan will give rise to an increase in the amount of money in the economy. In many countries, the ultimate cause of what is often chronic high inflation is the government's inability to finance public spending out of its regular revenues, prompting it to resort to inflationary means of financing the deficit (of course, this will not happen if the deficit is not financed by the central bank).

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