Factors affecting inflation rate

Updated March 23, 2017

There are a myriad of causes of inflation in the 21st-century economy, but they all boil down to basic supply and demand. If there is a high supply of money and a low demand for it, the price of goods rises, which in turn causes the value of money to fall. This is because money is only as good as what it can buy; if prices are higher in one year than they were the year previous, than any money made in that year is less valuable than it was at the time.

Cost-Push Inflation

Cost-push inflation is when the general price of goods rises because the costs associated with those goods rises. For example, if a new 5 per cent tax is passed onto every single company, then every company is going to raise its prices by 5 per cent in order to recoup its lost profits. This means that everyone who wants to buy something needs to pay an extra 5 per cent.

Demand-Pull Inflation

Demand-pull inflation is generally associated with growing economies. What happens in this case is that the demand for goods rises as incomes rise. This drives supply down, which causes producers to raise the price of their goods.

A number of factors can cause demand-pull inflation, but they are all linked with people in general being able to make more money. For example, if a country's currency loses value on the international markets, then the profit margins from exporting goods are going to rise. This will increase incomes, which will in turn increase demand, which will in turn cause demand-pull inflation.

Credit's Role

The central bank's role in an economy is to set the interest rates at which it will lend money to other banks. If it sets it at a high rate, people will be less inclined to borrow money to finance things like new enterprise, which reduces overall demand and can curtail inflation. However, the central bank can also do the opposite by making credit easily accessible.

This is what is important, though: the central bank tries to set credit at a level that does not encourage inflation. Therefore, it makes credit accessible when it appears as if the economy is not operating at its full potential. If it is not, and people are given cheap access to credit, then it will grow without prices growing and the value of money reducing. However, if it is at its full potential, then prices will rise.

Inflation occurs when the central bank lends money at cheaper rates than it should, which is often because it is impossible to determine the exact interest rates that will both maximise growth while minimising inflation. Rather, a balance needs to be struck somewhere in the middle as it tries to react to the economy's cost-push or demand-pull.

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About the Author

Sam Grover began writing in 2005, also having worked as a behavior therapist and teacher. His work has appeared in New Zealand publications "Critic" and "Logic," where he covered political and educational issues. Grover graduated from the University of Otago with a Bachelor of Arts in history.