What causes inflation?
the gap between supply and demand
inflation expectations and monetary policy
The measured inflation rate at any point in time will be made
up of an array of individual price changes. But the amount of
inflation in the economy is about more than just the sum of
all individual price changes. Something more fundamental determines
the amount of inflation in the economy - whether it is 1%, 10%
or 100%.
demand...
One of the underlying causes of inflation is the level of
monetary demand in the economy - how much money is being spent.
We can demonstrate this by considering what happens when the
prices of some products are rising. Imagine the price of cinema
tickets has risen. If consumers want to buy the same amount
of all goods and services as before, they will now have to
spend more - because the price of one of the products they
consume has risen. This will only be possible if their incomes
are rising, or alternatively if consumers are prepared to spend
a bigger proportion of their incomes and save less. But if
total spending does not rise, then higher prices will mean
consumers either will have to buy fewer cinema tickets or buy
less of something else. Any fall in demand for goods and services
will put downward pressure on prices. So although higher costs
or other factors might cause some prices to rise, there cannot
be a sustained rise in prices unless incomes and spending are
also rising.
On the other hand, if the price of some goods falls, people
will need to spend less to buy the same amount of all goods
and services as before. But if people still earn the same, they
will have the same amount of income as before. So they will
be able to buy more of those goods or of something else. Demand
in the economy will rise and this, in turn, might cause some
prices to rise.
Of course, this process takes time. And the situation will
be complicated if some people's incomes are affected by the
falls in prices - say because lower import prices cause firms
competing with imports to lose sales and reduce the number of
people they employ. However, it demonstrates a key feature of
inflation - that it relates to the amount of demand in the economy.
the underlying causes of inflation relate to the amount of
demand in the economy
... and supply
But inflation is not just about demand in isolation. Inflation
reflects the amount of demand in the economy relative to the
available supply of goods and services - in other words, the
amount of money people are spending relative to what can be
produced.
Inflation tends to rise when, at the current price level, demand
for goods and services in the economy is greater than the economy's
ability to produce goods and services - its output. One of the
original descriptions of inflation remains valid - that 'too
much money chases too few goods.'
the gap between demand and supply 
How much the economy is able to produce will reflect the rise
of the working population. Increases in output will also depend
on factors that enable more output to be produced from available
resources - in other words, productivity increases. The amount
the economy is able to produce, ie supply, might increase due
to the introduction of new technologies, extra investment in
new equipment, improved methods of production and distribution
or by enhancing the skills of the workforce. These things can
all lead to higher productivity.
There will be some price level at which there is a broad balance
between the demand for, and supply of, goods and services. At
this point there tends to be no upward or downward pressure
on inflation. Firms will be working at their normal capacity
- producing everything they can in the most efficient way with
their existing resources.
too much demand...
But what happens if there is an increase in demand for some
reason, for example due to a reduction in income tax, or because
consumers suddenly feel more optimistic and start spending more
money rather than saving?
when demand rises above what firms can produce at their normal
level of operation there tends to be upward pressure on costs
and prices
Firms can usually increase production to meet higher demand.
But this may only be possible by incurring higher costs. For
example, it might be necessary to introduce overtime working
or hire extra people. If many firms are trying to recruit extra
people in order to produce more, wages might start to rise.
And firms might have to pay more for additional materials or
run their processes and machinery in a less efficient way.
So to produce more, firms increase their demand for resources
and this may result in upward pressure on production costs and
prices - for example, the price of bricks and the wages of bricklayers
might rise if there is high demand for the construction of new
buildings such as houses or offices.
At the same time, imports are likely to rise and the gap between
what the country imports and exports - it's trade balance -
might widen. Higher prices in general might lead people to demand
higher wages so they can still buy the same amount of goods
and services. An increase in wage costs might then feed through
to a further rise in prices. The inflation process can then
continue until prices have risen to such a level that demand
is once again equal to supply.
... too much supply
The opposite to this is when there is slack - ie spare capacity
- in the economy. That is when the amount that can be produced
is greater than demand. In this situation, there tends to be
downward pressure on costs and prices.
inflation is usually generated by an excess of demand over
supply
To contain inflationary pressures in the economy, demand needs
to grow roughly in line with output. Output grows over time
at a rate which largely depends on factors which increase productivity.
If demand grows faster than this, unless there is spare capacity
in the economy - such as after a recession - inflation is likely
to rise.
We say more about demand, output and inflation in 'Inflation'
under the heading 'What
is monetary policy for? in 'Inflation Outlook' under the
heading 'Assessing
economic conditions' and in 'The Economy' under the heading
'Demand and
output'.
inflation expectations and monetary
policy
Even when demand and supply (output) are roughly balanced,
inflation will not necessarily be zero or indeed particularly
low and stable. When firms and employees negotiate wages and
when companies set their prices, they often consider what inflation
might be in the period ahead, say the next year. Expected inflation
matters for wages and prices because future price rises reduce
the amount of goods and services that today's wage settlement
can buy. So, if inflation is expected to be high, employees
might push for a higher wage increase.
if people expect inflation, their behaviour can lead to inflation
If wage settlements build in these expectations, then firms'
costs increase, which in turn could be passed on to customers
in higher prices. So if people expect inflation, their behaviour
can lead to inflation.
What determines the expected rate of inflation? The simple
answer is monetary policy and how much people believe in the
ability and commitment of the authorities - the government and
the central bank - to achieve their inflation objectives. People
have to believe that there will be low inflation before they
stop building expectations of high inflation into their decisions.
The authorities have to demonstrate that they will not allow
inflation to rise - that they will act to ensure demand does
not rise too much ahead of output.
The ultimate cause of inflation can really be said to be central
banks, like the Bank of England. Their behaviour and actions
determine whether inflation is allowed to rise or is kept low
- in other words, whether they allow prices to rise unchecked
by monetary policy, or whether the central banks seeks to influence
the amount of money in the economy by changing interest rates.
To keep inflation low, we want to ensure that the growth
in demand does not get ahead of the growth in what the economy
can produce. We want output to rise, but at a steady rate across
the economy as a whole and not so fast that the resulting demand
for resources generates upward pressure on costs and prices.
©2000-2009 Bank of England.
