Core Causes of Inflation: Production Costs, Demand, and Policies

Central banks influence inflation by manipulating interest rates to regulate the money supply. In 2022, crude oil prices jumped from around $70 to over $120 per barrel due to global events, raising transportation and manufacturing costs and, in turn, consumer prices. For example, during busy holiday seasons, high demand and limited stock push businesses to increase prices. At its core, inflation is the general increase in prices for goods and services, causing a steady loss in the purchasing power of money.

Other events might qualify if they lead to higher production costs, such as a sudden change in government that affects the country’s ability to maintain its previous output. A company might have no choice but to increase prices to help recoup some of the losses from a disaster. A worker strike due to stalled contract negotiations might also lead to a decline in production and, as a result, lead to higher prices. As stated earlier, an increase in the cost of input goods used in manufacturing, such as raw materials, is a cause of cost-push inflation.

Economic Uncertainty and Reduced Investment

• Demand-Pull Inflation occurs when the aggregate demand in an economy surpasses aggregate supply.
• The U.S. Energy Information Administration is a key source for data and analysis on energy prices and trends.
• However, most of the hiring this year has been heavily concentrated in just a few sectors — health care, restaurants and hotels, and government (outside of October).
• The Consumer Price Index (CPI) is the best-known inflation indicator.
• In simpler terms, it means that as inflation increases, each unit of currency buys fewer goods and services.
• Recent inflationary surges were driven by supply chain disruptions and rising energy and food prices.

As a result, U.S. companies might have to eat the higher production costs, otherwise, risk losing customers to foreign-based companies. In other words, inflation can give businesses pricing power and increase their profit margins. Savers see their cash deposits eroded of purchasing power, while those who loan money at lower fixed interest rates are stuck with less valuable loans until they mature. The relative costs of servicing these debts become less expensive with inflation. Historically, governments have also implemented measures like price controls to cap costs for specific goods, with limited success.

If people expect inflation, it might become a self-fulfilling prophecy. For each of the above theories, the concern isn’t just the presence of inflation; perception and expectations also play a big part. Governmental policies may also contribute to structural maladjustments in the economy. But what causes underproductivity in a country’s domestic production and exports? Another version of the structural theory of inflation, this one concerning developing countries, focuses on conditions of underproductivity and the relationship to the gap between imports and exports. The idea that a “politically tolerable” level of unemployment might reduce or end inflation was shaken by the rapid wage inflation that occurred during severe recessions in later decades.

What are the effects of inflation on businesses?

Also, business owners can deliberately withhold supplies from the market, allowing prices to rise favorably. For example, if the economy is performing well and housing demand is high, home-building companies can charge higher prices for selling homes. For example, those who are invested in energy companies might see a rise in their stock prices if energy prices are rising. In general, inflation benefits borrowers with lower fixed interest rates and owners of assets that rise along with inflation. This is a contractionary monetary policy that makes credit more expensive, reducing the money supply and curtailing individual and business spending. Consumer demand was stimulated, in part, due to high levels of fiscal spending and monetary policy enacted to mitigate the economic impacts of the public health emergency.

The Short-Term Economic Benefits of Inflation

The cost of the lemons, sugar, and water you need to make your lemonade goes up from last month. But most expect inflation will continue to slowly cool in 2026 and move closer to the Fed’s 2% target. Annual inflation, according to the Federal Reserve’s preferred measure, actually ticked higher to 2.8% in September — the latest data available — from 2.7% in December 2024. Even though inflation fell sharply in 2023 and 2024 from a four-decade high, there was little improvement last year.

Or are last year’s weak job gains a sign of a stumbling economy that could get worse? Fast, accurate percentage calculators for everyday use.No ads, no clutter, just results. A clear, step-by-step guide to calculating percentage increase manually or with a calculator.

Each of these causes provides insight into how economy-wide price levels can shift over time. Learn about the different types of Treasury securities issued to the public as well as trends in interest rates and maturity terms. Understanding and properly managing inflation is just one key element to promoting a healthy, sustainable economy. However, the most common method for the central bank to contain inflation is the federal funds rate — the interest rate that banks charge one another for overnight borrowing. The Federal Reserve can attempt to contain inflation through a number of monetary policy tools.

The Impact on Consumers

Businesses also face higher borrowing costs, which can lead them to scale back investment and expansion plans. This led to increased wage pressures as businesses competed for available workers. The U.S. dollar’s devaluation in the early 1970s, with oil priced in dollars, also contributed to OPEC’s decision to raise prices to maintain revenues.

Inflation refers to the rate at which the general level of prices for goods and services rises, leading to a decrease in purchasing power. However, if wage growth doesn’t keep up with inflation, reduced consumer spending power might shift demand away from discretionary items. This erosion of purchasing power can lead to reduced real incomes if wages do not increase at the same rate as inflation, making it harder to save or plan finances effectively. For individuals, it implies that their money buys less—the cost of living increases. This includes adjusting interest rates, controlling money supply, and implementing measures to stabilize currency value and incentivize investment. These effects necessitate responsive strategies from both individuals and organizations to protect economic interests and to capitalize on potential opportunities arising during inflationary periods.

Cost-Push Inflation: When Production Gets More Expensive

The Fed’s tools are primarily designed to influence aggregate demand, whereas cost-push inflation originates from problems on the economy’s supply side—such as oil embargos, global supply chain disruptions, or widespread crop failures. When inflation becomes a concern, both the Federal Reserve (through monetary policy) and the U.S. government (through fiscal and supply-side policies) have tools they can use to try bringing prices under control. Sharp oil cost rises directly increased production and transportation expenses for vast arrays of goods and services throughout the U.S. economy. Volcker shifted the Fed’s focus to controlling money supply and allowed interest rates to rise to unprecedented levels.

To compensate for the increased cost of production, producers raise the price to the consumer to maintain profit levels while keeping pace with expected demand. If the company doesn’t raise prices, while production costs increase, the company’s profits will decrease. Inflation can erode a consumer’s purchasing power if wages haven’t increased enough or kept up with rising prices. Cost-push inflation can also be influenced by higher wages, taxes, and supply-chain issues, or when higher costs decrease the aggregate supply in the economy. Cost-push inflation happens when businesses raise the price of goods and services because the cost of producing them increases. Cost-push inflation is a form of inflation caused by an increase in the cost of production inputs, such as raw materials and wagers, that leads to an increase in prices.

An expansion of money supply when there aren’t enough goods and services to buy naturally leads to price increases. This sustained surge in consumer demand can push prices higher as businesses struggle to keep up. This scenario, scaled up to the entire economy, illustrates demand-pull inflation. If beef prices rise sharply, consumers might buy more chicken, and the PCE index is designed to reflect such substitutions more quickly than the CPI. The U.S. Department of Labor defines inflation as “the overall general upward price movement of goods and services in an economy.” This ongoing price rise means your money’s purchasing power decreases over time. For example, recent rate hikes from near zero to above 4% demonstrated how tightening monetary policy can slow inflation and stabilize prices.

The poor are also less likely to own assets like real estate, which has traditionally served as an inflation hedge. Policymakers and financial market participants often focus on core inflation. They have less of a cushion against the loss of purchasing power that’s inherent in inflation. The Federal Reserve focuses on the PCE Price Index in its inflation targeting. The Consumer Price Index (CPI) is the best-known inflation what financial liquidity is asset classes pros and cons examples indicator.

Demand-pull inflation typically responds well to monetary policy tightening, though at potential costs to employment and growth. Both demand-pull and cost-push inflation present unique challenges requiring different policy approaches. However, such measures need careful design to be targeted and temporary, as broad or prolonged support can be costly and may inadvertently sustain demand, potentially worsening inflation if supply issues persist. Monetary policy by itself is often insufficient or comes with high costs in terms of lost output when dealing with supply shocks. Contractionary fiscal policy (reducing deficits through spending cuts or tax increases) can accounting technology work with monetary policy to cool overheating economies. The historical example of the Volcker Fed in the early 1980s demonstrates that aggressive interest rate hikes can successfully curb even very high and entrenched inflation, though often at the cost of recession.

• In 2023, inflation reached 10%, which was faster than wage growth of 6%
• Policymakers, believing they could “buy” permanently lower unemployment rates by tolerating modestly higher inflation, pursued expansionary policies that ultimately proved unsustainable and led to accelerating price increases.
• When the cost of such goods rise, so too does the price of the final goods and services that use the input, thereby leading to inflation.
• If the public and financial markets believe the Fed is credible and committed to maintaining low and stable inflation, they’re less likely to expect prolonged high inflation periods.
• Investors can enjoy a boost if they hold assets in inflation-promoting markets.
• To cover these higher costs, companies often raise prices for consumers.

However, if inflation becomes very high or unpredictable, it can create uncertainty about future costs, returns, and economic stability, which might deter some long-term business investment. While growth is generally desirable, if it’s fueled by unsustainable demand levels that outstrip supply, resulting inflation can create instability and ultimately undermine long-term, healthy economic expansion. Demand-pull inflation has wide-ranging effects on individual consumers and the broader U.S. economy. These causes indicate that demand-pull inflation often signals an economy “overheating,” where demand grows at an unsustainable pace relative to supply capacity. If domestic production can’t meet both domestic and new export demand, prices can be pulled upward.