What Causes Inflation? the Reason Behind the Current Inflation

Inflation is an economic phenomenon characterized by a sustained increase in the general price level of goods and services in an economy. The main determinants of inflation are:

1. Money supply: An increase in the money supply leads to an increase in prices as more money chases the same number of goods and services, leading to demand-pull inflation.
2. Government spending: An increase in government spending leads to an increase in prices as the government competes with the private sector for resources, leading to demand-pull inflation.
3. Taxes: An increase in taxes leads to an increase in prices as businesses pass on the increased costs to consumers, leading to cost-push inflation.
4. Interest rates: An increase in interest rates leads to an increase in prices as businesses pass on the increased costs to consumers, leading to cost-push inflation.
5. Exchange rates: An increase in the value of a currency leads to an increase in prices as imported goods become more expensive, leading to demand-pull inflation.
6. Commodity prices: An increase in commodity prices leads to an increase in prices as businesses pass on the increased costs to consumers, leading to cost-push inflation.
7. Wages: An increase in wages leads to an increase in prices as businesses pass on the increased costs to consumers, leading to cost-push inflation.
8. Inflation expectations: An increase in inflation expectations leads to an increase in prices as businesses anticipate higher costs and raise prices accordingly, leading to demand-pull inflation.

Among these determining factors, which one is the most important?

Reference [1] answered this question by using a technique called a Hidden Markov Model.

This technique assumes the observed values come from multiple distributions that switch according to a hidden regime characteristic. Additionally, each regime has a degree of persistence from one period to the next. For example, if we are in an accelerating inflation regime this month, this regime might be more likely to prevail next month, as well. But there is also a chance that the regime will shift abruptly to a decelerating inflation regime. The term Markov refers to the assumption that the underlying regime characteristic follows a Markov process in that next period’s regime probability depends only on the regime we are in today.

The authors applied this method in order to identify the most important factor that causes inflation,

We deployed a Hidden Markov Model to identify regimes of shifting inflation based on inflation data from January 1960 through February 2022. This analysis uncovered four distinct regimes: a Steady regime in which inflation was stable and volatility was low; a Rising Stable regime in which inflation was rising and volatility was low; a Rising Volatile regime in which inflation was rising and volatility was high; and a Disinflation regime in which inflation was declining sharply…

Our analysis revealed that spending by the federal government stands out as the most important determinant of the recent spike in inflation.

Briefly, government spending is the most important determinant of recent inflation.

References

[1] Kinlaw, William B. and Kritzman, Mark and Metcalfe, Michael and Turkington, David, The Determinants of Inflation (2022). https://ssrn.com/abstract=4137861

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