Inflation is an increase in the prices of goods andservices. The most well-known indicator of inflationis the Consumer Price Index (CPI), which measuresthe percentage change in the price of a basketof goods and services consumed by households(see Explainer: Inflation and its Measurement).The CPI is the measure of inflation used by theReserve Bank of Australia in its inflation target,where it aims to keep annual consumer priceinflation between 2 and 3 per cent (see Explainer: Australia's InflationTarget). Other measures of inflation are alsoanalysed, but most measures of inflation move insimilar ways over the longer term.
This Explainer describes the main causes ofchanges in the inflation rate.
Causes of inflation
The main causes of inflation can be grouped intothree broad categories:
- demand-pull,
- cost-push, and
- inflation expectations.
As their names suggest, ‘demand-pull inflation’ iscaused by developments on the demand side ofthe economy, while ‘cost-push inflation’ is causedby the effect of higher input costs on the supplyside of the economy. Inflation can also result from‘inflation expectations’ – that is, what householdsand businesses think will happen to prices in thefuture can influence actual prices in the future.These different causes of inflation are consideredby the Reserve Bank when it analyses andforecasts inflation.[1]
Demand-pull inflation
Demand-pull inflation arises when the totaldemand for goods and services (i.e. ‘aggregatedemand’) increases to exceed the supply of goodsand services (i.e. ‘aggregate supply’) that can besustainably produced. The excess demand putsupward pressure on prices across a broad rangeof goods and services and ultimately leads to anincrease in inflation – that is, it ‘pulls’ inflation higher.
Aggregate demand might increase because there isan increase in spending by consumers, businessesor government, or an increase in net exports. As aresult, demand for goods and services will increaserelative to their supply, providing scope for firmsto increase prices (and their margins – which istheir mark-up on costs). At the same time, firms willseek to employ more workers to meet this extrademand. With increased demand for labour, firmsmay have to offer higher wages to attract newstaff and retain their existing employees. Firms mayalso increase the prices of their goods and servicesto cover their higher labour costs.[2]More jobsand higher wages increase household incomesand lead to a rise in consumer spending, furtherincreasing aggregate demand and the scope forfirms to increase the prices of their goods andservices. When this happens across a large numberof businesses and sectors, this leads to an increasein inflation.
The opposite will happen when aggregatedemand decreases; firms facing lower demandwill either pause hiring or make staff redundantwhich means that fewer staff are required. This putsupward pressure on the unemployment rate.More workers searching for jobs means that firmscan offer lower wages, putting downward pressureon household incomes, consumer spending andthe prices of their goods and services. As a result,inflation will decrease.
The supply of goods and services that canbe sustainably produced is also known as theeconomy's potential output or full capacity. At thislevel of output, factors of production, such aslabour and capital (which includes the machinesand equipment firms use to produce their goodsand services) are being used as intensively aspossible without putting upward pressure oninflation. When aggregate demand exceeds theeconomy's potential output, this will put upwardpressure on prices. When aggregate demand isbelow potential output, this will put downwardpressure on prices.
So how can we measure how far the economyis from its potential output (or full capacity) andwhat does this mean for inflation? While we canfairly accurately measure aggregate demand ona quarter to quarter basis using gross domesticproduct (GDP) data from the national accounts(see Explainer: Economic Growth), potentialoutput is not directly observable − that is, wehave to infer it from other evidence about thebehaviour of the economy. For instance, justas there is a level of output where inflation isstable, there is also a level of the unemploymentrate that is consistent with stable inflation. It isknown as the Non-Accelerating Inflation Rate ofUnemployment or NAIRU for short (see Explainer:The Non-Accelerating Inflation Rate ofUnemployment (NAIRU)). When unemployment isbelow the NAIRU, inflation will increase and when itis above the NAIRU inflation will decrease.
Cost-push inflation
Cost-push inflation occurs when the total supplyof goods and services in the economy whichcan be produced (aggregate supply) falls. A fall inaggregate supply is often caused by an increasein the cost of production. If aggregate supply fallsbut aggregate demand remains unchanged, thereis upward pressure on prices and inflation – that is,inflation is ‘pushed’ higher.
An increase in the price of domestic or importedinputs (such as oil or raw materials) pushes upproduction costs. As firms are faced with highercosts of producing each unit of output they tend toproduce a lower level of output and raise the pricesof their goods and services. This can have flow-oneffects by pushing up the prices of other goodsand services. For example, an increase in the priceof oil, which is a major input in many sectors of theeconomy, will initially lead to higher petrol prices.However, higher petrol prices will also make it moreexpensive to transport goods from one location toanother which, in turn, will result in increased pricesfor items like groceries.
Cost-push inflation can also arise due to supplydisruptions in specific industries – for example,due to unusual weather or natural disasters.Periodically, there are major cyclones and floodsthat damage large volumes of agriculturalproduce and result in significant increases in theprice of processed food and both takeaway andrestaurant meals, resulting in temporary periods ofhigher inflation.
Imported inflation and the exchange rate
Exchange rate movements can also affect pricesand influence inflation outcomes. A decreasein the value of the domestic currency − that is,a depreciation − will increase inflation in twoways. First, the prices of goods and servicesproduced overseas rise relative to those produceddomestically. Consequently, consumers pay moreto buy the same imported products and firmsthat rely on imported materials in their productionprocesses pay more to buy these inputs. Theprice increases of imported goods and servicescontribute directly to inflation through thecost-push channel.
Second, a depreciation of the currency stimulatesaggregate demand. This occurs because exportsbecome relatively cheaper for foreigners to buy,leading to an increase in demand for exportsand higher aggregate demand. At the sametime, domestic consumers and firms reduce theirconsumption of relatively more expensive importsand shift their purchases towards domesticallyproduced goods and services, again leading toan increase in aggregate demand. This increasein aggregate demand puts pressure on domesticproduction capacity, and increases the scope fordomestic firms to raise their prices. These priceincreases contribute indirectly to inflation throughthe demand-pull channel.
In terms of imported inflation, the exchangerate has a greater influence on inflation throughits effect on the prices of goods and servicesthat are exported and imported (known astradable goods and services), while prices ofnon-tradable goods and services depend moreon domestic developments.
Inflation expectations
Inflation expectations are the beliefs thathouseholds and firms have about future priceincreases. They are important because expectationsabout future price increases can affect currenteconomic decisions that can influence actualinflation outcomes. For example, if firms expectfuture inflation to be higher and act on thosebeliefs, they may raise the prices of their goods andservices at a faster rate. Similarly, if workers expectfuture inflation to be higher, they may demandhigher wages to make up for the expected lossof their purchasing power. These behaviours,sometimes called ‘inflation psychology’, cancontribute to a higher rate of actual inflation so thatexpectations about inflation become self-fulfilling.
Given that inflation expectations can influenceactual price and wage setting, the extent towhich inflation expectations are ‘anchored’has implications for future inflation outcomes.For example, if households' and firms' expect thatinflation will return to the central bank's inflationtarget at some point in the future, regardlessof what current inflation is, we describe theirexpectations as being ‘anchored’ to the inflationtarget. When expectations are anchored, a periodof higher inflation – perhaps resulting from acost‑push event – will not cause households andfirms to change their behaviour and, as a result,inflation is likely to eventually return to its target.But if the inflation psychology of households andfirms shifts and inflation expectations move awayfrom the central bank's inflation target (i.e. theybecome ‘unanchored’), a period of higher inflationwill become persistent because households andfirms will expect inflation to be higher in thefuture and adjust their behaviour accordingly.Consequently, it is much easier for a central bankto manage inflation if inflation expectations areanchored rather than unanchored.
Illustrative Example of Anchored and
Unanchored Inflation Expectations
Inflation expectations over the longer runremain little changed in response to aperiod of higher inflation. Households andfirms expect the increase in inflation tobe temporary and do not change theirbehaviour, seeing the actual rate of inflationreturn to the central bank's inflation target.
Inflation expectations over the longer runmove higher in response to a period ofhigher inflation. Households and firms adjusttheir behaviour as they expect the increasein inflation to be more persistent, eventuallyleading to a higher rate of actual inflation.
While inflation expectations have an important influence on actual inflation outcomes, they are notdirectly observable. Instead, policymakers such as the Reserve Bank have to rely on measures of expectedinflation that are based on surveys (where people are asked their views about the inflation outlookdirectly) or financial assets like government bonds (where the price of the asset reflects assumptions madeabout the future path of inflation, see Explainer: Bonds and the Yield Curve).
Box: Supply Shocks and Stagflation
If a supply shock is sufficiently large or persistent, it not only causes cost‑push inflation, but cannoticeably reduce both the current and potential level of output in an economy. In this case, therecan be the unusual combination of a period of ‘stagnation’ as output declines at the same timethat prices are rising. This combination of stagnant growth – with high or rising unemployment– and high inflation is referred to as stagflation. Stagflation can become entrenched when inflationexpectations are not well anchored.
The 1970s were a period of stagflation that featured two oil price shocks. In October 1973, themembers of OPEC (the Organization of Petroleum Exporting Countries), as well as Egypt and Syria,imposed an oil embargo on industrial nations that had supported Israel in the Yom Kippur Warof the same period. The embargo resulted in a quadrupling of oil prices and energy rationing,culminating in a global recession in which unemployment and inflation surged simultaneously.Central banks did not target inflation at this time, and this was the start of a prolonged period ofhigh inflation in many economies.
Endnotes
See the Bulletin article on ‘Explaining Low Inflation Using Models’ for more information.[1]
Labour accounts for a large share of most firms' total costs of production. The effect of an increase in the cost of labour on inflationdepends on both the growth in wages and the productivity of labour. Labour productivity refers to how much output can be producedper worker or per hour worked (see Explainer:Productivity). If wages rise more quickly than labour productivity, the cost to the firm ofproducing each unit of output also increases – pushing up prices and inflation. [2]
