Inflation is a term used to describe the rate at which prices increase over time. In this article, we will discuss the three main types of inflation: demand-pull, cost-push, and built-in inflation, along with their own unique causes, real-life examples, and how they affect the economy.
- Inflation is usually classified into three types: demand-pull, cost-push and built-in inflation
- Demand-pull inflation is caused by demand outpacing supply
- When the cost of production goes up and causes prices to rise we talk about cost-push inflation
- Built-in inflation is the expectation that prices will continue to rise, which can lead to a price-wage spiral
What is demand-pull inflation?
Demand-pull inflation occurs when there is more demand for goods and services than there is supply. Put more simply, it happens when too many consumers are trying to buy too few goods. People are usually willing to pay more for something that they need but is in short supply.
This can happen during times of strong economic growth, when consumer and business confidence is high, and people have more money to spend and are willing to pay more for various products and services. As demand increases faster than supply, companies may raise their prices to maximize their profits, which in turn can lead to a general increase in prices in the economy.
The important difference compared to other types of inflation is that here, inflation is triggered by an increase in overall demand first. As demand then outpaces supply, prices rise.
There are several factors that can cause demand-pull inflation. Here are some of the main reasons:
- Increase in consumer spending
- Increase in government spending
- Expectations of future inflation
- Technological innovations
- An expanding money supply
What are some examples of demand-pull inflation?
Here are some real-world examples of demand-pull inflation:
- Housing market: When there is a strong demand for housing, prices of homes and rental rates may rise, leading to demand-pull inflation. A specific example is the rising popularity of mortgage-backed securities (subprime mortgages) in the years leading up to the 2008 financial crisis, which led to increased home prices.
- Consumer electronics: When a company releases a new in-demand product, such as Apple rolling out its latest iPhone, there could be a surge in demand for these products, leading to an increase in prices and inflation.
- Energy prices: An increase in demand for energy, for example during periods of cold weather, can lead to an increase in energy prices, causing inflation.
What is cost-push inflation?
Cost-push inflation occurs when the cost of production increases and these rising costs are essentially passed on to the consumers of the end products, as companies try to maintain their profits. This results in higher prices, leading to an increase in the overall price level of an economy.
This type of inflation can be caused by factors such as an increase in the cost of raw materials, rising wages, higher taxes, or a rise in the cost of energy needed for production. Supply chain disruptions, including extreme cases such as natural disasters, can also lead to higher costs for producers.
Compared to demand-pull inflation, where the trigger is an increase in demand first as explained above, the trigger for cost-push inflation comes from rising costs firsts.
What are some examples of cost-push inflation?
Some real-world examples of cost-push inflation are the following:
- Increase in energy prices: In the 1970s, the Organization of Petroleum Exporting Countries (OPEC), which controls the majority of the world's oil reserves, restricted its production, causing a significant incease in global oil prices. This led to an increase in the cost of production and subsequently, in the prices of all related goods and services.
- Supply chain disruptions: the COVID-19 pandemic of 2020 disrupted global supply chains and led to shortages of various raw materials, causing prices to rise. The pandemic also led to an increase in the cost of labor due to safety measures, contributing to a rise in the cost of production and thus an increase prices.
- Natural disasters: Australia suffered a severe drought in 2006-2007, which led to a significant increase in the cost of water and feed for livestock. Due to the resulting rise in the cost of production, the prices for agricultural goods such as wheat and meat also went up.
- Increase in taxes: When a government increases taxes on certain products or services, companies may raise their prices to cover the additional costs. By passing on these costs to consumers, end prices rise, fueling inflation.
What is built-in inflation?
Built-in inflation is a type of inflation that is based on developments that have happened in the past expected to happen in the future as well. Thus, the same expected outcomes with regard to inflation are "built into" the expectations for the future.
In essence, it is based on the idea that people expect the current inflation rate to continue in the future as well.
As workers expect that prices will rise, they ask their employers for a wage increase, since they wish to maintain their standard of living, i.e. be able to buy the same things they did before.
Due to their wages increasing, the cost of production at the company they work will go up, in turn leading the company to increase prices to maintain their profits. This vicious circle then leads back to the beginning, and things start over - this is also referred to as a wage-price spiral.
The result is an inflationary cycle that reinforces itself and manifests as built-in inflation in the economy.