7.7: What Causes Inflation?

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Martin Medeiros
Chabot College

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Think of all the things that determine a good's selling price. You must consider the costs of inputs, the level of competition, consumer tastes, and many other factors before you can make any price predictions. Therefore, it isn't too surprising that there are many causes of inflation.

But we can group most causes of inflation into three categories.

demand-pull
cost-push
trade

I can sum up this category in one succinct phrase: too many dollars chasing too few goods. This is the classic “Economics 101” scenario of demand exceeding supply. An increase in the consumer's ability to spend (possibly due to an increase in disposable income or the availability of credit) usually leads to an increase in the demand for goods and services. If this increase in demand is unexpected by the business sector, businesses may not have the ability in the short term to increase production so that supply can meet demand. As a result of this lag between demand and supply, prices are pushed upward.

Cost-push inflation occurs when rising production costs leads businesses to increase prices, passing the burden onto consumers. These higher costs can stem from various sources, such as rising wages, increased raw material prices, or supply chain disruptions. A classic example occurred in the 1970s when the Organization of Petroleum Exporting Countries (OPEC) reduced oil production, causing energy prices to spike. Since energy is a fundamental input for many industries, this cost increase raises the price of goods and services across the economy. See figure 5.

Figure 5

Similarly, if labor unions negotiate higher wages, businesses may respond by raising prices to maintain profitability. Other factors, such as natural disasters disrupting supply chains or government-imposed tariffs on imported goods, can also contribute to cost-push inflation. Unlike demand-pull inflation, which is driven by excessive consumer demand, cost-push inflation originates from constraints on the supply side, making it particularly challenging to control without reducing overall economic activity.

In 2024, the United States imported goods and services totaling approximately $4.1 trillion. This represents an increase of $187.1 billion compared to 2023. Foreign-made goods command a significant portion of every dollar spent in the product markets, and changes in the prices of imported goods and services influence the overall inflation rate. For example, a rise in the foreign exchange rate of the U.S. dollar makes imports cheaper, thereby lowering the cost of imported goods and constraining prices of similar, domestically produced goods. This has a depressing effect on the overall inflation rate.

How can tariffs affect inflation?

A tariff is a tax imposed on imported goods, which can contribute to inflation by raising the cost of those goods and leading businesses to pass higher costs onto consumers.

Tariffs can contribute to inflation by increasing the cost of imported goods, leading businesses to pass those higher costs onto consumers through higher prices. When tariffs are imposed on essential inputs, such as raw materials or intermediate goods, production costs rise, further driving up prices across various industries. This cost-push inflation can reduce consumers' purchasing power and slow economic growth. Additionally, tariffs can disrupt supply chains, causing shortages that further inflate prices. However, in some cases, tariffs may protect domestic industries, potentially stabilizing certain sectors but often at the expense of higher overall consumer prices.

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