What causes inflation?

Question

Given the recent increases in the price of many things in the US (lumber, used cars, gasoline, etc…) I have begun thinking about what is going on at a macroeconomic level. My first thought is “it’s inflation” but then I can rationalize to myself that a surge in demand following a “reopening” “after” the pandemic leads to a supply shortage and this can drive prices up. Ok, so a supply demand imbalance can lead to rising prices, without inflation. This is something I can understand… but if this doesn’t cause inflation, what does? What other mechanism exists that drives inflation if not supply/demand changes?

Answer 1

A rise in prices is inflation. So, to some extent there has been inflation after the pandemic. Some key examples are:

• Lumber prices have increased as a result of several supply chain disruptions and increased demand, which drives up the price of pallets, and therefore... everything else.
• Demand is way up for numerous products as customers are attempting to "make up for" lost leisure time.
• Home prices are way, way up. They represent the single largest purchase for consumers, so this has a fairly strong influence.

However, I get the intuition that economists (myself included) seem to be fairly confident that most of these disruptions in the supply chain will be smoothed out over time and fairly quickly at that. Demand will probably return to normal levels once the population has gotten the year of restrictions "out of their system", which will drop prices again. Take a look at the inflation changes over the history- the current spike, while nonzero, seems modest and on the tail of a substantive deflationary period. An example of more substantive inflation would be around 1972-1975, where the values are strongly positive for a long period of time.

Still, these inflation values never really approach the hyperinflation values that one may learn about in introductory econ of 100% per year - or anything like that.

I had the privilege to see the chairman of the NYC fed here (https://www.linkedin.com/feed/update/urn:li:activity:6808924128217747456) and the basic point he was able to communicate is that they are monitoring the situation (they are always monitoring the situation), but more importantly he did not mention that there was cause for concern. Sometimes, with these officials, it's about what they didn't say.

Answer 2

I think you are bit confused about what inflation even is.

On Inflation

Ok, so a supply demand imbalance can lead to rising prices, without inflation. This is something I can understand…

The above sentence does not show correct understanding of inflation.

Inflation by definition is the increase in aggregate price level, and aggregate price level is just aggregation of individual prices. If prices increase all over economy then by definition there is an inflation. You can't have all prices increase without inflation, because definitionally inflation is the aggregate overall change in prices.

Note, it is possible to have prices increase in some markets without inflation, but only if in some other markets prices decrease. For example, if in market for milk prices increase by 10%, but if in market for meat prices drop by 10%, all else being equal inflation would be zero. However, it is not possible to have generally rising prices all over economy without there being inflation as that is what inflation is by definition.

"Surface-Level" Macroeconomics of Inflation

Actually, from surface level macro perspective inflation is caused just by shifts of aggregate supply and aggregate demand. This is because aggregate price level is given by intersection of aggregate supply and aggregate demand of whole economy, and whenever aggregate supply or aggregate demand shift in some way that increases the aggregate price level you have inflation in the economy.

For example, shift in the aggregate supply to the left (or some authors would say up) would lead to inflation. Or shift in the aggregate demand to the right (or some authors would say up) would lead to inflation (see the graphs I drew in tikz below, in the graph $P$ is aggregate price level $AD$ aggregate demand, $AS$ aggregate supply, and $Y$ output of the economy).

However, this is just a "surface-level" explanation because, even though aggregate price level level is determined by aggregate demand and aggregate supply, AD and AS are not themselves independent and they are determined by other forces. I will explain this in next section.

"Deeper-Level" Macroeconomics of Inflation

On deeper level, aggregate price level (change of which gives you inflation), is determined by the money market equilibrium (which is one of the building blocks that you can use to construct AS-AD see Woodford Interest & Prices for graduate level treatment or Blanchard et al Macroeconomics for more beginner friendly treatment). The money market equilibrium is given by:

$$M/P = L(Y,i)$$

where $M$ is money supply, $P$ aggregate price level, and $L$ is the liquidity demand that depends on output $Y$, and interest rate $i$. A less accurate (but for a novice more useful) representation would be given by the quantity theory of money representation, where $L$ is just expressed as $Y/V$ (where $V$ depends on interest rate):

$$\frac{M}{P} = \frac{Y}{V} \implies P = \frac{MV}{Y}$$

Linearizing the equilibrium condition above and examining how it changes with respect to time we can arrive at the following relationship (where $\Delta x =dx/x$):

$$ \Delta P = \Delta M + \Delta V - \Delta Y$$

So inflation $\Delta P>0$ is caused by positive change in money supply, which is controlled by the government via central bank, positive change in velocity of money, that is how much one unit of currency is used in the economy on average (which varies inversely with interest rate) and by negative change in real output, which changes due to all the factors that affect societies ability to produce output (e.g. technology, availability of factors of production etc.).

In addition, the model above is still an oversimplification as in real life people form expectations, and often act on the expectations of things happening rather than things actually happening. Consequently, what matters is also how well inflation expectations are anchored, and what people expect will be happening in the real economy (e.g. see discussion of this in Bems et al (2018). Expectations' Anchoring and Inflation Persistence. International Monetary Fund).

There is also bit more nuance to all of this that you can explore in the literature I listed above, but overall these are main factors determining inflation.

Answer 3

Inflation is a generalized rise of prices at a determinated market during a specific period of time (usually seasonally adjusted).

Inflation is everytime and everywhere a monetary phenomenon (meaning, it's caused by action of central banks). For example, the most argued situation by heterodox economists is an oil crisis driving prices up, which in my opinion is the best example of a person not understanding basic economics.

If there is an undersupply of oil and the price of energy goes up, the demand for final goods is simply going to fall because of the budget constraint impeding people to escort the upward trajectory of prices. This obviously would case a situation of oversupply, which at the end would be solved either by lower prices followed by diminished returns of the producers or by lower production which in turn would cause lower oil prices, reestablishing the equilibrium point.

This is explored in-depth by the masterbook of prices history (40 Centuries of Prices and Wages Control: How not to Fight Inflation).