What causes inflation?

What is causing inflation?

Inflation is now at 9.1 percent—the highest rate in more than 40 years. The prices of essential goods such as gas, groceries, and rent have all risen, making it difficult for Americans, especially those with lower incomes, to get by.

Inflation is an economic term to describe a situation when prices rise in the economy. It means goods and services are becoming more expensive, and your monthly paycheck won’t buy as much as it previously could.

But what are the primary drivers of inflation? Why is America experiencing historic inflation? And what can policymakers do to lower prices?

Let’s take a look.

Inflation: When demand exceeds supply

As the American Enterprise Institute explains, inflation is the result of aggregate demand exceeding aggregate supply. Americans want more TVs, furniture, cars, and homes, for example, but for various reasons, there aren’t enough of those products. Because of this increased demand, the price for those products increases.

This increase in demand is often a result of an increase in money supply. Famed economists Milton and Rose Freedman noted in their book Free to Choose, “A more rapid increase in the quantity of money than in the quantity of goods and services available for purchase will produce inflation, raising prices in terms of that money.”

So, now we know the primary driver of inflation is when there’s more money than goods that money can buy, what exactly caused the historic inflation that began in 2021 and continues today?

The increase in money we’re seeing today is primarily driven by:

The pandemic
Policies from Washington DC

How the pandemic contributed to inflation

When the coronavirus hit in March 2020, it sent millions of workers home and essentially shut down the economy. Lockdowns to slow the spread of the virus brought the world’s largest economy to a screeching halt. As businesses reopened and the economy began to recover, Americans were able to spend again—increasing demand for all kinds of goods. Supply just couldn’t keep up.

The pandemic caused massive disruptions to supply chains across the world. Worker shortages played a key role in these disruptions. Many businesses struggled to find employees, which slowed down production. And in the United States, prolonged federal unemployment benefits kept many workers from reentering the workforce—a policy that exacerbated the worker shortage and inflation.

Which brings us to another key driver of increased money supply…

How policies from Washington DC led to inflation

Milton Freedman also noted that excessive monetary growth, and hence inflation, is produced by governments. Namely, governments increase the quantity of money by financing government spending that’s not backed by taxes.

In March 2021, President Biden signed the $1.9 trillion coronavirus relief package—a plan that sent up to $1,400 payments to most Americans. It also provided billions in aid to state and local governments and billions for COVID-19 vaccines. At a time when the economy was already recovering from the pandemic, critics questioned whether this additional stimulus was necessary. After all, this package was on top of the $3 trillion lawmakers passed in 2020 bipartisan budget stimulus measures.

What these pieces of legislation did was pump trillions of dollars into the economy—which increases the amount of money in circulation. As we noted above, when there’s more money than goods that money can buy, the result is inflation.

What can lawmakers do to lower prices?

To cure inflation, government needs to stop spending. Unfortunately, this will trigger a recession and more unemployment—but thankfully, that will only be temporary. Once government reduces spending, inflation will subside, and the economy will recover.

Beyond a halt in government spending, it’s the job of the Federal Reserve, or the central bank of the United States, to stabilize prices and regulate the financial system. The Fed will often raise interest rates to combat inflation. Raising interest rates makes it harder for Americans to borrow money—reducing supply and lowering inflation. In June 2022, the Fed raised interest rates by 0.75 percentage point, the largest increase since 1994. Many experts argue the Federal Reserve waited much too long to raise interest rates, which only made inflation worse.

**Are there steps states can take to lower inflation?**

Taming inflation is a job that will ultimately lie with the federal government. However, there are steps states can take to help Americans cope with these historic prices. States can cut taxes, reduce regulations, increase the housing supply, and help get people back to work—policies that will make it easier for American families to deal with sky-high prices.