What is Inflation? Demand-pull and Cost-push

Back in 1964, you could buy a McDonald’s meal for only 47 cents and now it costs around $3.99. Have you ever wondered about what could have changed in these 57 years? The answer is Inflation. 

 

What is Inflation ?  

 

According to the definition, “Inflation is the rate at which the general level of prices for goods and services is rising and, in the opposite, the purchasing power of currency is falling”.

 

This implies that as prices of goods and services rise, the currency will lose its value as it will be able to purchase a less number of goods now. For any country, Inflation is a major changing factor for their economic growth. Three things which affect inflation are demand, supply and expectations of goods.

 

Recommended read: An introduction to financial analysis

 

The problem with printing money

 

You might wonder what would happen if the Government printed loads of money in an attempt to solve the problem of money, but here is the thing: an increase in the supply of money is the root cause of inflation. 

 

Let me explain this with an example. Back in the old times, people used silver coins in the exchange of goods. The government then collected all the silver coins and melted them, and also mixed other metals such as copper or lead to produce more coins at the same nominal value (initial value). By diluting the silver, the government produced more coins without increasing any amount of silver. This approach allowed the government to make profits because now the cost to make each coin is lowered while the value remains the same. This practice increases the money supply while simultaneously reducing the value of each coin, which results in consumers being required to give more coins in exchange for the same goods and services as before. In the present scenario, we can replace older coins with the new currency in order to get an idea of why the government cannot merely print more money to solve the problem of inflation.

 

Inflation Formula

 

Rate of inflation = (CPI_X+1-CPI_X)/ CPI_X

 

CPI_X+1 = consumer price index for given X+1 period

CPI_X = consumer price index for X period time

X   =   time

 

Consumer price index formula

 

CPI_t = (C_t/C₀)* 100

 

CPI_t = consumer price index in the current period

C_t = cost of the market basket in the current period

C₀ = cost of the market basket in the base period

 

Inflation Rate

 

As the name implies, it is a percentage of increase and decreases in the prices of goods and services during a certain period, generally a month or a year.

 

For example, if the inflation rate for a gallon of crude oil is 4% per year, then the crude oil prices will be 4% higher in the next year. That means if suppose, a gallon of crude oil price is $3 this year. it will cost $3.12 next year.

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Impact of inflation on the price of coffee

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According to this inflation calculator, $100 in 2000 is worth $153 in 2020 which implies an average inflation rate of 2.15% and cumulative inflation of 52.96%, will be worth $196 in 2030 if we use an inflation rate 2.50% from 2021-30.

 

The inflation rate is an important factor for the misery index, which is a combination of the unemployment rate and inflation. The misery index is an economic indicator which helps us to understand the average citizen’s financial health.

 

Another relevant blog: What is Financial Analysis?

 

 

Why Inflation Occurs

 

There are many schools of thoughts regarding the cause of inflation. The cause can generally be divided into two broad categories: 1) Demand-pull inflation  2) Cost-push inflation

 

1. Demand-pull inflation

 

It is caused due to aggregate demand increasing faster than aggregate supply. Imagine a scenario where there is suddenly increased demand for electric cars owing to the environmental policy imposed by the Government, so now due to the limited supply of electric vehicles, all the sellers will increase their prices which would result in demand-pull inflation. 

 

Causes of demand-pull inflation:

 

• Economic growth: This occurs when consumers feel confident then they can afford to spend more and take more debt; hence the increase in demand leads to an increase in price.

 

• Asset inflation: This generally occurs when the currency of a particular economy suddenly depreciates, (providing more money in the hands of the importers) while the production of goods remains constant, hence sudden increase in demand (Import demands) resulting in an increase in price. 

 

• Government spending: This occurs when the government spends capital on large scale projects creating an increase in demand overall because of trust, which leads to an increase in price and demand-pull inflation.

 

• Inflation forecasts: When the government or media outlets forecast inflation, it will unintentionally cause demand-pull inflation. In this situation, companies may increase their price to meet the expected inflation, and consumers may buy more thinking of future increase in price.

 

• Exorbitant supply of money: More money in the system increases the buying power of consumers, leading to an increase in price. As the definition of demand-pull inflation fits here “too much money chasing too few goods”.

 

We have seen multiple examples of demand-pull inflation, such as when COVID-19 was declared as a pandemic, the price of hand-sanitisers, face masks, and majority FMCG goods increased due to a sudden increase in demand.

 

2. Cost-Push Inflation

 

Cost-push inflation occurs when there is a substantial increase in the cost of goods and no alternative is available. Increase in cost of production like machinery, labour or increase in the cost of raw materials, can cause cost-push inflation.

 

Cost-push inflation lowers the economic growth of a country and causes a fall in living standards, although cost-push inflation proves to be temporary.

 

Causes of cost-push inflation:

 

• Increase in price of commodities: Rise in crude oil prices would lead to higher petrol/diesel prices and transportation costs, which in turn would lead to all companies having to increase their price of goods owing to higher transportation cost. 

 

• Higher Wages: High wages will lead to higher production cost because for any firm it is their main cost. High wages can also generate demand-pull inflation.

 

• Higher Taxes: Higher VAT/Taxes can also cause an increase in the price of goods. Many imported products prices are high due to higher excise duties.

 

• Profit-push inflation: When a company gains a monopoly in an industry, it can increase its price to make more profit which will lead to cost-push inflation.

 

• Imported inflation: If a country devalues its currency, then the import price of goods will go up; hence it will increase the prices of imported goods.

 

In 1970, due to some geopolitical events, OPEC (Organization of the Petroleum Exporting Countries) imposed an oil embargo on the United States and other countries, while also imposing oil production cuts. It created a supply shock and quadrupled the prices from $3 to $12 per barrel. Since there was no increase in demand, there was a surge in gas prices and higher production costs for companies which are using petroleum products.

 

Key Takeaways

 

• Inflation is the rate at which the general prices of goods and services rises, while the purchasing power of the currency declines. 

 

• Throughout the blog, an insight on what inflation is, why it occurs and its formula has been discussed. 

 

• Rate of Inflation formula = (CPI_x+1 – CPI_x ) / CPI_x

 

• The cause of Inflation can generally be divided into two broad categories namely, Demand-pull inflation and Cost-push inflation.