Intro: Concepts such as cost-push, demand-pull, second round effects, and wage-price spirals reflect proximate causes of inflation, rather than ultimate causes. In reality, inflation is the byproduct of the interaction between the production of real goods and services, the money available to purchase them, and the willingness of people to spend this money rather than hoard it.
Demand-pull inflation is a term that tends to be used to when an economy is growing strongly while cost-push inflation tends to be used when there is a spike in the price of key economic input like oil which feeds through into higher prices across the board. However, such concepts are largely meaningless as they focus on the proximate causes of inflation rather than the ultimate causes.
Take for example a spike in global oil prices. This can be highly inflationary in some cases yet not inflationary at all in other cases. The reason being that for an oil price spike to translate into a rise in inflation across the board, one or two things must take place. Either, money supply must rise, or people must become more eager to spend the money they already have. In the absence of either of these two developments, any increase in spending that goes on higher oil prices will be counterbalanced by a reduction in spending in other goods leaving overall inflation unchanged.
The spike in oil prices can act as a trigger for people to become more eager to spend their existing cash balances through fear that prices will continue to rise, which in turn can create higher inflation, but this is by no means necessarily the case. When a spike in oil prices does lead to a sustained rise in inflation as a result of either a subsequent increase in money supply or an increase in the eagerness to spend existing cash balances, this is often referred to as ‘second round effects’.
In the case of so-called ‘demand-pull’ inflation, the textbook idea is that there is too much aggregate demand in the economy versus aggregate supply. This is patently absurd given that humans will always demand more stuff than we are able to supply. In reality, demand-pull inflation is used to describe episodes when rapid increases in the money supply are causing prices to rise even in the absence of a rising supply of goods and services.
The CPI Basket: Cause Versus Effect
It is tempting to argue when looking at the breakdown of a CPI basket that its individual components caused the overall rise in inflation. So, for instance, let’s say that headline CPI rises 3.0% y-o-y in a particular month and within the CPI basket we see that clothing rises 10.0%. It is tempting to argue that inflation was caused by the increase in clothing prices. However, this is an example of the fallacy of composition. In the absence of rising money supply or alternatively a fall in overall output, any increase in the price of clothing would be more or less offset by falling prices of other goods and services as there simply wouldn’t be enough money to go around. In reality, rising clothing prices are a symptom of inflation and not a cause.
Wage price spirals occur when wages rise forcing up prices, which, in turn causes them to demand higher wages, in turn causing prices to rise further and so on and so forth. However, as with a spike in oil prices, wage-price spirals can only occur if there is either a constantly increasing amount of money supply, or an increase in people’s willingness to spend their existing money.