3 types of inflation: Demand-pull inflation, Cost-push inflation, Built-in inflation
Chim
Gordon calls the "triangle model":
Demand-pull inflation: inflation caused by increases in aggregate
demand due to increased private and government spending, etc. Demand
inflation is constructive to a faster rate of economic growth since
the excess demand and favourable market conditions will stimulate
investment and expansion. The failing value of money, however, may
encourage spending rather than saving and so reduce the funds
available for investment.
Cost-push inflation: presently termed "supply shock inflation," caused
by drops in aggregate supply due to increased prices of inputs, for
example. Take for instance a sudden decrease in the supply of oil,
which would increase oil prices. Producers for whom oil is a part of
their costs could then pass this on to consumers in the form of
increased prices.
Built-in inflation: induced by adaptive expectations, often linked to
the "price/wage spiral" because it involves workers trying to keep
their wages up (gross wages have to increase above the CPI rate to net
to CPI after-tax) with prices and then employers passing higher costs
on to consumers as higher prices as part of a "vicious circle." Built-
in inflation reflects events in the past, and so might be seen as
hangover inflation.
A major demand-pull theory centers on the supply of money: inflation
may be caused by an increase in the quantity of money in circulation
relative to the ability of the economy to supply (its potential
output). This is most obvious when governments finance spending in a
crisis, such as a civil war, by printing money excessively, often
leading to hyperinflation, a condition where prices can double in a
month or less. Another cause can be a rapid decline in the demand for
money, as happened in Europe during the Black Plague.
The money supply is also thought to play a major role in determining
moderate levels of inflation, although there are differences of
opinion on how important it is. For example, Monetarist economists
believe that the link is very strong; Keynesian economics, by
contrast, typically emphasize the role of aggregate demand in the
economy rather than the money supply in determining inflation. That
is, for Keynesians the money supply is only one determinant of
aggregate demand. Some economists consider this a 'hocus pocus'
approach: They disagree with the notion that central banks control the
money supply, arguing that central banks have little control because
the money supply adapts to the demand for bank credit issued by
commercial banks. This is the theory of endogenous money. Advocated
strongly by post-Keynesians as far back as the 1960s, it has today
become a central focus of Taylor rule advocates. But this position is
not universally accepted. Banks create money by making loans. But the
aggregate volume of these loans diminishes as real interest rates
increase. Thus, it is quite likely that central banks influence the
money supply by making money cheaper or more expensive, and thus
increasing or decreasing its production.
A fundamental concept in Keynesian analysis is the relationship
between inflation and unemployment, called the Phillips curve. This
model suggests that there is a trade-off between price stability and
employment. Therefore, some level of inflation could be considered
desirable in order to minimize unemployment. The Phillips curve model
described the U.S. experience well in the 1960s but failed to describe
the combination of rising inflation and economic stagnation (sometimes
referred to as stagflation) experienced in the 1970s.
Thus, modern macroeconomics describes inflation using a Phillips curve
that shifts (so the trade-off between inflation and unemployment
changes) because of such matters as supply shocks and inflation
becoming built into the normal workings of the economy. The former
refers to such events as the oil shocks of the 1970s, while the latter
refers to the price/wage spiral and inflationary expectations implying
that the economy "normally" suffers from inflation. Thus, the Phillips
curve represents only the demand-pull component of the triangle model.
Another Keynesian concept is the potential output (sometimes called
the "natural gross domestic product"), a level of GDP, where the
economy is at its optimal level of production given institutional and
natural constraints. (This level of output corresponds to the Non-
Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural"
rate of unemployment or the full-employment unemployment rate.) If GDP
exceeds its potential (and unemployment is below the NAIRU), the
theory says that inflation will accelerate as suppliers increase their
prices and built-in inflation worsens. If GDP falls below its
potential level (and unemployment is above the NAIRU), inflation will
decelerate as suppliers attempt to fill excess capacity, cutting
prices and undermining built-in inflation.
However, one problem with this theory for policy-making purposes is
that the exact level of potential output (and of the NAIRU) is
generally unknown and tends to change over time. Inflation also seems
to act in an asymmetric way, rising more quickly than it falls. Worse,
it can change because of policy: for example, high unemployment under
British Prime Minister Margaret Thatcher might have led to a rise in
the NAIRU (and a fall in potential) because many of the unemployed
found themselves as structurally unemployed (also see unemployment),
unable to find jobs that fit their skills. A rise in structural
unemployment implies that a smaller percentage of the labor force can
find jobs at the NAIRU, where the economy avoids crossing the
threshold into the realm of accelerating inflation.