Learning Objectives

• Identify the difference between demand-pull inflation and cost-push inflation
• Identify patterns of inflation for the United States using data from the Consumer Price Index
• Identify patterns of inflation on an international level

Demand-Pull vs. Cost-Push Inflation

Demand-pull inflation occurs when there is an increase in aggregate demand. When aggregate demand increases, there is an increase in real GDP and the price level. As the price level increases, there is inflation. Demand-pull inflation is caused by any of the reasons that cause aggregate demand to increase. In others words, as the economy expands, especially if it expands beyond full employment, shortages occur in markets, and when shortages occur, prices increase. If prices increase in many markets, the price level will increase, and the economy experiences inflation.

Cost-push inflation occurs when there is an increase in the cost of producing goods and services. This may be caused by higher resource prices, higher energy prices, or higher labor costs. Historically, higher oil prices have often caused higher production costs. As productions costs increase, aggregate supply decreases, the price level increases, and there is inflation. In other words, as businesses have to pay more to produce goods and services, they will pass on those cost increases to consumers in the form of higher prices. If this occurs across the economy, the price level increases, and there is inflation.

Demand-pull inflation is generally regarded as less of a macroeconomic problem than cost-push inflation, as it also results in more output. In fact, policymakers often prefer a steady, low rate of inflation to no inflation. Cost-push inflation is a more serious problem, since it is usually combined with less output. As costs increase, not only do businesses pass on those costs as higher prices, they also produce less. Less production may result in a recession. Thus, cost-push inflation may lead to the problem of stagflation, the combination of recession and inflation. This is a very difficult problem to deal with.

Historical Inflation in the U.S. Economy

Figure 8.3 (a) shows the level of prices in the CPI stretching back to 1916. In this case, the base years, when the CPI is defined as 100, are set for the average level of prices that existed from 1982 to 1984. Figure 8.3 (b) shows the annual percentage changes in the CPI over time, which is the inflation rate.

Figure 8.3 U.S. Price Level and Inflation Rates since 1913 Graph (a) shows the trends in the U.S. price level from the year 1916 to 2014. In 1916, the graph starts out close to $10, rises to around $20 in 1920, stays around $16 or $17 until 1931, when it jumps to around $15. It gradually increases, with periodic dips, until 2014, when it is around $236. Graph (b) shows the trends in U.S. inflation rates from the year 1916 to 2014. In 1916, the graph starts out at 7.7 percent, jumps to close to 18 percent in 1917, drops drastically to close to –11 percent in 1921, goes up and down periodically, until settling to around 1.5 percent in 2014.

The first two waves of inflation are easy to describe in historical terms: They are right after World War I and World War II. However, there are also two periods of severe negative inflation, called deflation, in the early decades of the twentieth century: one following the deep recession of 1920–21 and the other during the Great Depression of the 1930s. Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation will be a time when the buying power of money in terms of goods and services increases. For the period from 1900 to about 1960, the major inflations and deflations nearly balanced each other out, so the average annual rate of inflation over these years was only about one percent per year. A third wave of more severe inflation arrived in the 1970s and departed in the early 1980s.

Link It Up

Visit this website to use an inflation calculator and discover how prices have changed in the last 100 years.

Times of recession or depression often seem to be times when the inflation rate is lower, as in the recession of 1920–1921, the Great Depression, the recession of 1980–1982, and the Great Recession in 2008–2009. There were a few months in 2009 that were deflationary, but not at an annual rate. Recessions are typically accompanied by higher levels of unemployment, and the total demand for goods falls, pulling the price level down. Conversely, the rate of inflation often, but not always, seems to start moving up when the economy is growing very strongly, like right after wartime or during the 1960s. The frameworks for macroeconomic analysis, developed in other chapters, will explain why recession often accompanies higher unemployment and lower inflation, while rapid economic growth often brings lower unemployment but higher inflation.

Inflation around the World

Around the rest of the world, the pattern of inflation has been very mixed, as can be seen in Figure 8.4 which shows inflation rates over the last several decades. Many industrialized countries, not just the United States, had relatively high inflation rates in the 1970s. For example, in 1975, Japan’s inflation rate was over eight percent and the inflation rate for the United Kingdom was almost 25 percent. In the 1980s, inflation rates came down in the United States and in Europe and have largely stayed down.

Figure 8.4 Countries With Relatively Low Inflation Rates, 1960–2014 This chart shows the annual percentage change in consumer prices compared with the previous year’s consumer prices in the United States, the United Kingdom, Japan, and Germany.

Countries with controlled economies in the 1970s, like the Soviet Union and China, historically had very low rates of measured inflation, because prices were forbidden to rise by law, except for the cases where the government deemed a price increase to be due to quality improvements. However, these countries also had perpetual shortages of goods, since forbidding prices to rise acts like a price ceiling and creates a situation where quantity demanded often exceeds quantity supplied. As Russia and China made a transition toward more market-oriented economies, they also experienced outbursts of inflation, although the statistics for these economies should be regarded as somewhat shakier. Inflation in China averaged about 10 percent per year for much of the 1980s and early 1990s, although it has dropped off since then. Russia experienced hyperinflation—an outburst of high inflation—of 2,500 percent per year in the early 1990s, although by 2006 Russia’s consumer price inflation had dipped below 10 percent per year, as shown in Figure 8.5. The closest the United States has ever gotten to hyperinflation was during the Civil War, 1860–1865, in the Confederate states.

Figure 8.5 Countries with Relatively High Inflation Rates, 1980–2013 These charts show the percentage change in consumer prices compared with the previous year’s consumer prices in Brazil, China, and Russia. (a) Of these, Brazil and Russia experienced hyperinflation at some point between the mid-1980s and mid-1990s. (b) Though not as high, China also had high inflation rates in the mid-1990s. Even though their inflation rates have come down over the last two decades, several of these countries continue to see significant inflation rates. Sources: (Federal Reserve Bank of St. Louis, 2013a; Federal Reserve Bank of St. Louis, 2013b; Federal Reserve Bank of St. Louis, 2013c)

Many countries in Latin America experienced raging hyperinflation during the 1980s and early 1990s, with inflation rates often well above 100 percent per year. In 1990, for example, both Brazil and Argentina saw inflation climb above 2,000 percent. Certain countries in Africa experienced extremely high rates of inflation, sometimes bordering on hyperinflation, in the 1990s. Nigeria, the most populous country in Africa, had an inflation rate of 75 percent in 1995.

In the early 2000s, the problem of inflation appears to have diminished for most countries, at least in comparison to the worst times of recent decades. As we noted in the Bring it Home feature that began this chapter, in recent years, the world’s worst example of hyperinflation was in Zimbabwe, where at one point the government was issuing bills with a face value of $100 trillion (in Zimbabwean dollars)—that is, the bills had $100,000,000,000,000 written on the front, but were almost worthless. In many countries, the memory of double-digit, triple-digit, and even quadruple-digit inflation is not very far in the past.