Two of the main drivers of inflation are cost-push inflation and demand-pull inflation.

Cost-push inflation is a decrease in the aggregate supply of goods and services, often stemming from an increase in the cost of production. Demand-pull inflation is an increase in aggregate demand. "Aggregate" means all four sections of the economy: households, businesses, governments, and foreign buyers.

Cost-push inflation and demand-pull inflation are two of the potential causes of inflation. The others are an increase in the money supply of an economy and a decrease in the demand for money.

Inflation is the rate at which the overall prices of goods and services rise. This, in turn, causes a drop in purchasing power. The prices of individual goods and services rise and fall all the time. However, inflation happens when prices rise across the economy to a measurable degree.

Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When the aggregate supply of goods and services decreases, often due to an increase in production costs, it results in cost-push inflation.

Cost-push inflation means prices have been "pushed up" by increases in the costs of any of the four factors of production—labor, capital, land, or entrepreneurship—when companies are already running at full production capacity. Companies cannot maintain profit margins by producing the same amounts of goods and services when their costs are higher and their productivity is maximized.

The price of raw materials may also cause an increase in costs. This may occur because of a scarcity of raw materials, an increase in the cost of labor to produce raw materials, or an increase in the cost of importing raw materials. The government may also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more resources to paying taxes.

To compensate, the increase in costs is passed on to consumers, causing a rise in the general price level: inflation. Another way cost-push inflation occurs is that the supply of the final product declines or grows slower than the demand because the high costs discourage production. Since supply no longer meets demand, prices rise.

For cost-push inflation to occur, demand for goods must be static or inelastic. That means demand must remain constant while the supply of goods and services decreases.

An example of cost-push inflation is the oil crisis of the 1970s. The price of oil was increased by OPEC countries while demand for the commodity remained the same. As the price continued to rise, the costs of finished goods also increased, resulting in inflation.

The price-quantity graph below demonstrates how cost-push inflation works. It shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2.

Companies that want to maintain or increase profit margins will need to raise the retail price paid by consumers, thereby causing inflation.

Demand-pull inflation occurs when there is an increase in aggregate demand, which consists of the total demand from four sections of the macroeconomy: households, businesses, governments, and foreign buyers.

When concurrent demand for output exceeds what the economy can produce, the four sectors compete to purchase a limited amount of goods and services. That means the buyers "bid prices up" again and cause inflation. This excessive demand, also referred to as "too much money chasing too few goods," usually occurs in an expanding economy.

In Keynesian economics, aggregate demand is viewed as the economy's driving force.

The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government spending can increase aggregate demand, thus raising prices.

Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases. This raises the overall level of aggregate demand, assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy.

Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if a government reduces taxes, households are left with more disposable income in their pockets. This, in turn, leads to an increase in consumer confidence that spurs consumer spending.

Looking again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, this will not change aggregate supply in the short run. Instead, it will cause a change in the quantity supplied, represented by a movement along the AS curve.

The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply.

As companies respond to higher demand with an increase in production, the cost to produce each additional output increases, as represented by the change from P1 to P2. That's because companies would need to pay workers more money (e.g., overtime) and/or invest in additional equipment to keep up with demand.

Just like cost-push inflation, demand-pull inflation can occur as companies pass on the higher cost of production to consumers to maintain their profit levels.

Governments and central banks have ways to counter both cost-push inflation and demand-pull inflation.

To counter cost-push inflation, supply-side policies need to be enacted with the goal of increasing aggregate supply. To increase aggregate supply, taxes can be decreased on business to stimulate production. Government action can be taken to lower the costs of raw materials or to help increase access to them.

Countering demand-pull inflation would be achieved by the government and central bank implementing contractionary monetary and fiscal policies. This would include increasing the interest rates, decreasing government spending, and increasing taxes, all measures that would reduce demand.

Four main factors are blamed for causing inflation:

During and following the COVID-19 pandemic in 2020 and 2021, the world saw a sharp increase in inflation. Global prices of certain key commodities rose sharply and kinks developed in the supply chain. By 2022, workers were successfully pressing for higher pay to cope with rising consumer prices. Price increases to cover the costs of higher pay pushed inflation higher. That is classic cost-push inflation.

The impacts of pandemic continue to linger in 2024, keeping average inflation rates much higher than they used to be before COVID-19.

An annual inflation rate of 2% is considered optimal by the Federal Reserve, which sets that figure as its goal for the U.S. economy.

The law of supply and demand is the linchpin of a market economy. What could go wrong? Two big things that can go wrong are cost-push inflation and demand-pull inflation.

Cost-push inflation is caused by a shortage of supply. Demand-pull inflation is caused by an increase in demand. Both cause negative impacts for consumers and businesses.