What Are The Causes Of Inflation? (With Pros And Cons)

Updated 30 September 2022

Inflation is an important economic concept that impacts everyone, as the rate of inflation directly influences the price of goods and increase in wages. There are different reasons and measures of inflation. Learning about inflation and its different sources can help you make better financial decisions and achieve your financial goals. In this article, we discuss the definition and causes of inflation, explain its different types and share the advantages and disadvantages of inflation.

Definition and causes of inflation

Knowing the definition and causes of inflation can help you make better financial decisions. Inflation is the sustained increase of average price levels in an economy and the decrease in purchasing power of its currency. Inflation measures how much the prices are increasing and how much extra money people have to spend to purchase the same commodities over a period of time. The inflation rate is usually in the form of a percentage and shows the rise or fall of prices during a particular period. High inflation levels can be detrimental to growth, investment and credit activity.

Broadly, there is either an increase in demand or a decrease in supply that results in a price rise. Here are three types of inflation that can help understand the source of inflation:

Demand-pull inflation

Demand-pull inflation results from an increase in prices due to high demand and lack of supply of products. When the demand for such goods is increasing faster than the production or supply, the resulting gap can cause inflation. This type of inflation can also occur if there is an increase in the supply of money or income sources to the people. This can lead to the availability of more disposable income and results in higher spending, which ultimately drives up demand and prices.

Other factors that can result in demand-pull inflation are:

Population increase: a sudden rise in the population and a consequent increase in the demand for goods and services
Unaccounted money: high usage of unaccounted money to purchase goods and services
High government expenditure: increased levels of government expenditure that results in higher public wages and income sources

Cost-push inflation

When the price of raw materials or other factors for producing goods increases, it can result in an overall rise in the price of the good. This is cost-push inflation, wherein the rise in prices is due to the increased cost of production. Another situation in which cost-push inflation occurs is when the demand or price of a good remains stagnant. In this case, the manufacturer of the product does not produce more than the required demand but increases the price for the existing customers to compensate for the gradual increase in the cost of production.

When faced with a rise in the price of raw materials, companies increase prices to preserve their profitability. Cost-push inflation is common after a natural disaster, where the demand may not rise as much, but the cost of supplying products increases which results in a price rise. Other factors that can result in cost-push inflation are:

Delays: delays in production that can increase the cost of raw material and distribution
Government intervention: an increase in the minimum prices of the products which the government guarantees to purchase
Global factors: price rise in the global market of raw materials
Manipulation: artificially manipulating the supply chain to hoard or black market products
Rise in taxes: a significant rise in the indirect taxes that the government levies on all goods and services

Built-in inflation

Built-in inflation refers to inherent expectations that result in a continuous wage and price rise to balance each other. For example, when people expect an increase in the price of goods and the average cost of living, they expect an increase in their wages. If a company gives its employees higher wages, the cost of production also goes up, which results in a price rise. This results in a cyclical cause-and-effect phenomenon where one influences the other.

It is important to note that most factors of inflation do not operate in isolation and may influence or even result in each other. For example, the demand for a wage increase by the factory employees may be due to a change in the income tax or indirect taxes collected by the government. Different reasons for inflation usually correlate or cause each other directly or indirectly.

Types of inflation index

Inflation indices are databases that help measure inflation. They usually represent the ratio of the price of one item, or many items, at one time to the price of the same items at a different time. Different indices use varied factors to calculate inflation, identify its cause and speculate future economic activity. Governments of all countries routinely calculate the inflation rate to design effective economic policies. Here are the two common types of inflation indices that the Indian government follows:

Consumer price index

The consumer price index, or CPI, refers to the general state of inflation for goods and services that people purchase. This index surveys the purchases, budgets and buying habits of the population and studies the household expenses to calculate the level of inflation. The Ministry of Statistics and Programme Implementation (MOPSI) calculates and publishes CPI data in India.

Wholesale price index and the producer price index

The wholesale price index, or the WPI, and the producer price index measure the changes in the price of goods and services before reaching the end retail customer. This helps track changes in inflation during the wholesale and production processes, respectively. These indices reflect the perspective of the seller and manufacturer instead of the customer. The Ministry of Commerce and Industry measures the WPI in India.

Advantages of inflation

Experts always strive to control inflation rather than completely eliminate it because it has a few important economic advantages:

May boost economic growth

When used effectively, inflation can help customers time their purchases and boost economic activity in the market. If the prices of a product or service continue dropping or witness negative inflation, people may defer their purchase, expecting a lower price in the future. Conversely, if there is moderate inflation, customers maintain healthy economic and purchasing activity.

Can improve output or productivity

Companies usually increase their output and productivity to maximise profits when the prices of their products are increasing. This can lead to an optimisation of resources. Similarly, when the workforce experiences a rise in the costs of the commodities they purchase, they may also work more to maintain their purchasing capacity.

Can help businesses undertake wage adjustment

A moderate rate of inflation can help organisations adjust relative wages easily. When the average wages are rising due to inflation, employers can increase the wages of productive employees and freeze the wages of unproductive employees. This helps adjust wages better than a situation with zero inflation when everyone's wages might be stagnant or cut.

Usually creates challenges that are relatively easier to solve

Some economic experts believe that dealing with inflation is better than managing deflation, as the latter can result in a recession. A sustained fall in the prices of goods and services can have a devastating impact on credit, investment and consumer spending. A moderate amount of inflation can be the sign of a healthy economy by some experts who believe it helps increase the output, productivity and wages.

Disadvantages of inflation

When inflation is uncontrollably high, it can lead to several challenges as well:

May lead to unsustainable growth

High inflation levels can result in unsustainable economic growth, which may witness boom-and-bust economic cycles. This is because any effort to control high inflation levels can directly lead to a sustained recession period. Economies with high inflation levels also tend to have lower rates of economic growth over a long period.

Can discourage investment

Inflation may suppress the investment demand, and people have lesser disposable income after accounting for their expenses. By reducing the value of savings, inflation can hurt the personal investment and loan industry. As the price of commodities is higher for people, the burden of existing loans becomes heavier, and it becomes more expensive for people to take new credit.

May make the economy uncompetitive

Due to high levels of inflation, the products and services in an economy become less competitive with respect to other countries. In a globalised world where the economies of different countries trade with each other, high levels of inflation in any one country can make it less desirable for others to purchase goods. This reduces its competitiveness as its trading partners may prefer other economies where the price of goods and services is lower and stable.

Can reduce real wages

If the rate of increase of prices of goods and services outpaces the rate of wage growth, it can decrease people's purchasing power. This can significantly impact people with fixed incomes, such as salaried professionals and pensioners. High levels of inflation can stagnate any real wage growth, or even worse, result in a declining rate of wage growth.

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