Causes of Inflation to Know for AP Macroeconomics

Understanding the causes of inflation is crucial in macroeconomics. It can stem from increased demand outpacing supply or rising production costs. Factors like monetary and fiscal policies, supply shocks, and wage dynamics all play significant roles in shaping inflation trends.

1. Demand-pull inflation

   • Occurs when aggregate demand in an economy outpaces aggregate supply.
   • Often driven by increased consumer spending, investment, or government expenditure.
   • Can be exacerbated by low unemployment rates, leading to higher wages and spending.
   • Commonly associated with economic growth periods and rising confidence in the economy.

2. Cost-push inflation

   • Results from rising costs of production, leading to decreased supply of goods and services.
   • Key factors include increased prices for raw materials, labor, and energy.
   • Often leads to stagflation, where inflation occurs alongside stagnant economic growth.
   • Producers pass on higher costs to consumers, resulting in higher prices.

3. Monetary policy expansion

   • Involves increasing the money supply or lowering interest rates to stimulate economic activity.
   • Can lead to increased borrowing and spending, contributing to demand-pull inflation.
   • Central banks may implement this policy during economic downturns to encourage growth.
   • Risks include potential overheating of the economy and rising inflation rates.

4. Fiscal policy expansion

   • Involves increased government spending or tax cuts to boost economic activity.
   • Aims to increase aggregate demand, which can lead to demand-pull inflation.
   • Often used during recessions to stimulate growth and reduce unemployment.
   • Can result in higher public debt if sustained over long periods.

5. Supply shocks

   • Sudden and unexpected events that disrupt the supply of goods and services.
   • Examples include natural disasters, geopolitical events, or pandemics.
   • Can lead to cost-push inflation as production costs rise and supply decreases.
   • Often results in immediate price increases for affected goods and services.

6. Wage-price spiral

   • Occurs when rising wages lead to increased production costs, prompting businesses to raise prices.
   • Higher prices can lead to demands for even higher wages, creating a cycle of inflation.
   • Often seen in tight labor markets where workers have more bargaining power.
   • Can contribute to sustained inflation if not controlled.

7. Built-in inflation (inflation expectations)

   • Refers to the expectation of future inflation influencing current wage and price-setting behavior.
   • Workers demand higher wages to keep up with anticipated price increases.
   • Businesses raise prices preemptively to cover expected higher costs, perpetuating inflation.
   • Central banks monitor inflation expectations to guide monetary policy decisions.

8. Currency devaluation

   • Occurs when a country's currency loses value relative to other currencies.
   • Makes imports more expensive, leading to higher prices for imported goods and services.
   • Can stimulate exports by making them cheaper for foreign buyers, but may also lead to inflation.
   • Often a result of government policy or economic instability.

9. Increase in money supply

   • Refers to the central bank's action to inject more money into the economy.
   • Can lead to lower interest rates, encouraging borrowing and spending.
   • If the increase outpaces economic growth, it can result in demand-pull inflation.
   • Must be managed carefully to avoid excessive inflation.

10. Decrease in aggregate supply

    • Occurs when the overall production capacity of the economy declines.
    • Can be caused by factors such as natural disasters, labor strikes, or regulatory changes.
    • Leads to higher prices as the supply of goods and services diminishes.
    • Often results in cost-push inflation as producers face higher costs and reduced output.