The causes of inflation

When the demand for a good or service increases beyond their supply, their price increases (people are willing to pay more to buy what they need).

If we apply this principle to the entire ISTAT basket, a rise in consumer demand can lead to inflation. This is the case with demand-pull inflation: a period in which consumer demand for goods and services is higher than the quantity supplied by the market.

Demand-pull inflation at the greengrocer's

In order to better understand the relationship between demand, supply and prices, let's picture a small greengrocer's in an old neighborhood, which only has one apple counter. Let's imagine that a large residential building block is erected not far from the market. The number of clients for the market will double in a short period of time and, when autumn comes, many more people will go to the market to buy apples.

The immediate effect is that our apple-seller will have people queueing at their counter, and will therefore be able to take advantage of owning the only apple counter and raise the prices.

However, in time, news will spread that there is good money in apples, and new sellers will arrive, whether in the same market or nearby, offering apples at increasingly lower prices in order to attract new clients. The increase in apple supply will drive down prices until a new supply/demand equilibrium is reached.

Excess demand over supply of a good can sometimes be caused by a sudden decline in production. A rise in prices can also occur due to an increase in production costs.

This is the case with supply-push (or cost-push) inflation: the demand for goods and services doesn't change, but either production capacity decreases or its costs increase. This can be caused by different factors, such as an unexpected event that impedes the provision and production of goods (e.g. a pandemic or a war), or an increase in the costs of raw materials, such as oil.

Supply-push inflation, still at the greengrocer's

Back at our apple market, let's imagine there is a surge in the costs of fertilizers and diesel oil. This makes growing apples and carrying them to the market more expensive. The market apple-sellers will react by charging their clients higher prices.

Let's now hypothesize/imagine a different scenario, an unexpected event such as a pandemic or a drivers' strike, which impedes the provision of apples: only half as many apples will be produced, which will generate a new imbalance between supply and the demand from households, who are now used to having three counters full of apples, so the price of apples will increase.

Sometimes high inflation may be due to a number of factors, relating to both supply and demand. For instance, the sharp increase in prices in the US during the post-pandemic economic recovery (2021-2022) can be explained both by the rise in demand (people started going out and spending, partly thanks to the government subsidies received during lockdown), and by the fall in supply due to businesses closing, which impeded the production and transport of goods all over the world.

Finally, long-term inflation can be caused by the amount of money in circulation exceeding the value of goods and services: too many euros chasing too few goods!

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