Types of Inflation
There are two primary types of inflation: demand-pull and cost-push. Understanding which type of inflation is occurring at any given point in time is important if policymakers want to respond appropriately. The two types of inflation are not mutually exclusive, so it is possible for both to occur simultaneously. Left untreated, inflation can cause a wage-price spiral or even hyperinflation.
Demand-pull inflation occurs when spending on goods and services drives up prices. Demand-pull inflation is fueled by income, so efforts to stop it involve reducing consumer's income or giving consumers more incentive to save than to spend.
Demand-pull inflation persists if the public or foreign sector reinforces it. Low taxes and profligate government spending exacerbate demand-pull inflation. A failure of the central bank to reign in the money supply also makes the demand-pull inflation worse.
Demand-pull inflation can spread across borders as well. China and India's economic growth not only puts pressure on prices in these countries but also on prices worldwide as the demand for imports increase.
If government spending is financed by printing currency or by the central bank monetizing the debt, demand-pull inflation can become hyperinflation. Hyperinflation is defined as annual inflation of 100% or greater. All cases of hyperinflation have been accompanied by the government or central bank issuing too much money.
What does “monetizing the debt” mean?
Monetizing the debt refers to the process by which the central bank buys new government debt, thus increasing the supply of money in circulation. When debt is monetized, the government is able to spend without raising taxes or borrowing from the private sector. The downside is that debt monetization is extremely inflationary.
Cost-push inflation occurs when the price of inputs increases. Businesses must acquire raw materials, labor, energy, and capital to operate. If the price of these were to rise, it would reduce the ability of producers to generate output because their unit cost of production had increased. If these increases in production cost are relatively large and pervasive, the effect is to simultaneously create higher inflation, reduce real GDP, and increase the unemployment rate.
You might recognize this combination by another name, stagflation. In the 1970s, OPEC cut oil production, which led to much higher energy prices along with double-digit inflation and unemployment. Because producers faced higher operating costs, they reduced output. Relative to the demand for their products, the supply decreased, which resulted in cost-push inflation.
If cost-push inflation has a bright side, it is the fact that it is self-limiting. Cost-push inflation is associated with decreases in GDP. The decreased GDP and resulting high unemployment helps to bring producer prices back down. The trick to combating cost-push inflation is realizing that it is not demand-pull. The policy prescription for each is different, and applying the wrong prescription can create more problems than it solves. It is the unemployment issue that usually spurs policymakers to action.
If they respond to the increased unemployment by increasing spending, the inflation problem is made worse. A wage-price spiral can result if the policy responses create more demand for goods and services at the same time that unit costs are rising. By way of analogy, the prescription for a grease fire is different from that of a forest fire. Grease fires are put out by removing the source of oxygen, while a forest fire is extinguished with water. If you pour water on a grease fire, then things only get worse. This is what happened in the 1970s. Instead of letting cost-push inflation run its natural course, the Fed poured money on it, and inflation worsened.