Decoding the Causes of Inflation: Distinguishing Between Supply and Demand vs. Money Printing Effects

Ascertaining the cause of inflation is a crucial concern for investors, policymakers, and the public. There are two main drivers of inflation: supply and demand imbalances, and excessive money supply.

In my approach to economics, I find it beneficial to first examine the behaviour and choices of individuals and then extrapolate to the broader economy. This methodology allows for a better understanding of how macroeconomic trends can arise from microeconomic actions and decisions.

This is also how I am able to understand what is likely to happen in the economy, by putting myself in the shoes of different people and considering what decisions they would make, then scaling it up to understand the whole economy.

To understand the likely outcome of supply/demand driven inflation, consider the budget of an individual. In the event of a sudden increase in gas prices, an individual operating under a fixed budget would be required to reduce expenses in other areas to compensate for the added cost. This entails cutting back on discretionary spending in order to allocate resources towards essential expenses such as food and fuel. Since they cannot simply generate additional funds, they would be obliged to limit expenditures on non-essential goods and services to offset the increased expenditure on necessary items.

As a consequence, they may opt to purchase takeaway meals instead of dining out at restaurants or choose to purchase clothes from a more affordable outlet, among other potential adaptations.

In situations where higher prices are a result of supply and demand factors and not due to monetary factors, it is reasonable to expect inflation to increase in certain necessary spending categories, with corresponding decreases in discretionary spending categories like services.

It is worth noting that individuals may draw on their savings rather than their regular income to manage the increased expenses. However, in such cases, inflation is typically transitory, as there is a limited pool of savings or assets that people can rely on to compensate for rising prices. Therefore, prices cannot remain high indefinitely, as this would eventually result in a deflationary scenario.

It is possible to delve into the concept of the wage-price spiral, wherein all prices tend to increase over time as income levels rise. However, it typically takes a considerable amount of time for inflation to become imbedded enough for individuals to recognise the need for a wage increase.

Therefore, when analysing early inflation data, if the increased inflation did not stem from the government's cash injection into the economy, we would expect to see higher inflation rates in certain areas, with lower inflation in others.

Conversely, we observed significant inflationary spikes across all goods and services due to the government's substantial injection of extra money into the economy. From a personal budget perspective, individuals would have had an overall greater budget to spend, such as those receiving furlough payments.

The primary cause for the substantial increase in inflation can be attributed to the fiscal policy measures implemented by the government during COVID, which included furlough payments. This is further evidenced by the data showing that inflation affected all sectors and by the fact that it typically takes about 18 months for any monetary or fiscal policy to fully take effect on the economy.

In my personal opinion, the inflation surge following COVID was predominantly a result of the government's fiscal policies such as furlough payments, which injected significant amounts of money into the economy. However, I also believe that if the inflation were supply-driven, we would have expected to observe an initial increase in necessary spending inflation and a decrease in inflation for discretionary spending.

In conclusion, determining the root cause of inflation is crucial for investors, policymakers, and the public. While there are two main drivers of inflation, namely supply and demand imbalances, and excessive money supply, understanding the behaviour and choices of individuals can help to extrapolate macroeconomic trends. Inflation stemming from supply and demand factors is expected to result in higher inflation rates in certain necessary spending categories, with corresponding decreases in discretionary spending categories. On the other hand, inflation caused by the government's cash injection into the economy, as seen during the COVID pandemic, typically leads to significant inflationary spikes across all goods and services. Therefore, while supply-driven inflation is likely to affect necessary spending first, inflation caused by excessive money supply is expected to impact all sectors.