Introduction to Inflation

Inflation is the rate at which the general level of prices for goods and services rises, leading to a fall in the purchasing power of money over time. It is usually measured annually and affects the cost of living and the value of currency within an economy.

Economists classify inflation into three main types based on its causes: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Inflation

• Definition: Demand-pull inflation occurs when the demand for goods and services in an economy exceeds the available supply. This imbalance leads to higher prices as too much money chases too few goods.

• Causes: Increased consumer spending, government expenditure, or investment can drive demand-pull inflation, especially when the economy is near full employment.

• Example: If people suddenly have more disposable income, they may buy more products than businesses can supply, causing prices to rise.

Cost-Push Inflation

• Definition: Cost-push inflation happens when the overall prices increase due to rising costs of production, such as higher wages or more expensive raw materials.

• Causes: Increases in wages, raw material costs, or energy prices can reduce the aggregate supply of goods and services, pushing up prices even if demand remains unchanged.

• Example: If oil prices rise sharply, transportation and manufacturing costs increase, leading companies to raise the prices of their products to maintain profits.

Built-In Inflation

• Definition: Built-in inflation, also known as wage-price spiral inflation, results from adaptive expectations—when people expect inflation to continue, they act in ways that perpetuate it.

• Mechanism: Workers demand higher wages to keep up with rising living costs. If employers grant these wage increases, they often raise prices to cover higher labor costs, leading to a cycle of rising wages and prices.

• Example: If inflation has been high in the past, both workers and businesses may expect it to persist, leading to ongoing wage and price increases even if the original causes of inflation have subsided.