The causes of inflation in the long run and in the short run

Over the long-term, several years and longer, prices increase because the supply of money in the economy is expanding, i.e. because central banks print more cash. There may be other reasons for inflation in the short run but over longer stretches of time printing money is the only cause of inflation.

Notice the rapid growth of money supply in Bolivia. The graph shows a typical measure of money supply known as "broad money" or "M2". The measure includes the cash circulating in the economy and the money people and companies keep on bank deposits. Although M2 could increase or decrease for various reasons from one year to the next, over longer periods of time it grows because the central bank is printing more money.

Notice on the second graph the rapid growth of consumer prices in Bolivia. Clearly, the printing of money that we see in the top chart has produced the inflation that we see in the chart below. Notice also that the two lines are not perfectly related. Money supply and prices can grow at different rates over a few years. However, when you look at a period of 10 or more years, the two lines are very closely tied.
Why do central banks print money? When the government cannot collect enough tax revenue and cannot keep its spending in check, it often pressures the central bank of the country to print cash and pay the government bills. The consequence of such policies is high inflation.

Inflation causes in the short run

In the long run inflation is produced by expanding money supply. In the short run, however, prices can fluctuate considerably because of other forces. We’ll name a few.

The business cycle. During rapid economic expansions when the economy operates almost at capacity and unemployment is very low, companies have to compete for workers by paying higher wages. They also pay more for various inputs such as raw materials. Real estate becomes more scarce and rent payments increase. Some of those price increases are passed on to the retail level causing inflation. When the economy cools downs, price increases subside.

The price of oil or other commodities. An increase in the price of an important product can bump up all prices in the economy. For example, if the price of oil increases this affects the vast majority of companies as their transport cost increases. That could be passed on to consumers on the retail level causing inflation.

Exchange rates. Changes in the exchange rates can be another source of inflation. Most countries import many of the products they consume: food, home equipment, cars, etc. If the exchange rate depreciates, then the prices of all those products would tend to increase lifting the overall price level.


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