The Rising Prices Puzzle

One of the most intriguing aspects of the economy is the perpetual increase in prices. If we look back in history, incomes and prices were drastically different compared to today. In Jane Austen's novel "Pride and Prejudice," Mr. Darcy was regarded as one of Britain's wealthiest individuals in 1813, with an annual income of £10,000. Surprisingly, that amount is less than half of what a newly graduated primary school teacher would earn in "Sense and Sensibility" today.

There has been a debate about whether an income of £20 per week is sufficient to be considered well-off, and the answer is yes. It's within living memory that a cinema ticket cost 30 pence in 1970, while today it amounts to £13. This begs the question: Why does inflation occur, and should we be concerned about it?

Governments meticulously track and aim to control inflation. They gather extensive data to precisely assess the inflation rate, whether it's on track for the targeted 2.3 percent per annum or if the slight increase of 0.38 percent in February should raise alarm. This concern about inflation is relatively recent in the grand scheme of history. In the 17th century, the Spanish Empire experienced a collapse due to inflation without even realizing it was happening. Consequently, societies have become fixated on measuring and managing inflation.

So, what causes inflation? There are essentially three primary reasons behind it. The first is what economists refer to as cost-push inflation. This occurs when businesses face rising costs and subsequently pass them on to customers. Various factors can contribute to these cost increases, such as the escalating prices of raw materials, particularly oil, driven by the development and success of many countries. Additionally, workers may demand higher wages, either due to effective political organization or a lack of workers trained in the specific skills that companies require. Moreover, land rents can increase when there is a shortage of factories and offices, often resulting from political failures related to building permits. Consequently, businesses are compelled to raise prices to offset these additional costs, even though it is an intimidating move they would rather avoid to remain operational.

The second type of inflation is known as demand inflation, which occurs when the number of people desiring a particular product surpasses the available supply. A common cause of demand inflation is the positive phenomenon of people becoming wealthier and having more disposable income. Interestingly, governments can stimulate inflation by lowering taxes, as tax breaks are generally popular since they increase disposable income. However, in the long term, increased demand can also drive up prices, neutralizing some of the initial benefits of tax breaks. Similarly, a decline in interest rates may provide short-term satisfaction but can lead to long-term inflationary pressure. If interest rates on loans or mortgages decrease, people may be tempted to acquire loans for purchases they have long desired, such as a new car. Sensing solid demand, car companies may raise prices accordingly. When banks and governments inject more cash and credit into the economy, individuals have more money to spend. However, if they are all competing for the same limited quantity of goods as before, it merely results in higher offers for the same items. A vivid illustration of this occurred in the UK housing market, particularly in London, where the number of houses remained relatively constant over 25 years, but prices skyrocketed.

The third classic cause of inflation is when governments print money. Although this concept may initially sound dubious, there is a rationale behind it. Governments often aim to stimulate the economy and create more jobs, so they increase the money supply. This can be achieved by physically producing more banknotes or by increasing government debt or allowing banks to provide larger loans with the same collateral.