During the last class, one of you asked me what causes inflation. This is an excellent question and, like everything else in (macro)economics there are several theories to explain the process.
- The classical theory: Assume that the Fed prints more money and circulates it into the economy. If the amount of goods and services produced are the same, then the extra cash floating around will make people buy more goods and services, but since the supply has not changed, it would cause a price increase or inflation.
- Aggregate supply and demand: If, for some reason, the amount of production in the economy decreases (because of a recession, say) then the aggregate supply (AS) will decrease, pushing prices up. If, over the long run, the aggregate demand (AD) increases (because of an increase in population due to migration), this will also cause prices to increase. Sometimes, both happen together – an increase in AD causes increased production, which causes a labor shortage which, in turn, causes wages to go up increasing costs of production. Thus, both AS and AD increase, causing a price increase.
- Expectations: Sometimes prices increase because firms think they will increase in the future. To avoid losses, they mark up their items earlier than they should. If they are part of a supply chain, all consequent links in that chain will also increase their prices, up to the retail outlets. The result? Inflation.
- The Phillips Curve: Professor A.W.Phillips studied unemployment and changes in wage levels from 1861 to 1957, and found they were inversely related. An increase in one meant a decrease in the other. So, according to the Phillips Curve, a decrease in unemployment results in an increase in prices.
These are some of the more dominant theories in economics about what causes inflation. Each of them have their critics and supporters – both of whom make valid points. Notwithstanding that debate though, one thing that most economists will agree on is that inflation is troublesome to everyone, and for many reasons.
We will be talking about this in much more detail when we get to Chapter 8. But if you are really interested, I suggest you read Hans Melberg’s Inflation: An overview of theories and solutions. It’s a very nicely written (and simple – for undergrads!) webpage, written by Dr. Melberg, when he was a Ph.D. student in Econ. Another resource is the U.K.’s “Bank of Biz/ed“.