The Consumer Price Index (CPI) measures inflation in an economy, which can be caused by demand-driven or cost-driven factors. Demand-driven inflation occurs when demand grows faster than supply, while cost-driven inflation occurs when companies incur increasing costs and pass them on to consumers. The CPI can rise due to changes in product quality or the introduction of new goods. Economists use these two theories to explain specific rises in inflation.
The Consumer Price Index (CPI) is an economic measure that tracks inflation in an economy. Inflation can occur for many reasons, with economists often debating the current and past causes of this phenomenon. A rise in the CPI can be the result of one of two options: demand-driven inflation or cost-driven inflation. All theories about a rise in the CPI typically fall under one of these two general economic concepts. One theory states that inflation occurs when too many dollars chase too few goods, while the other states that as business costs rise, so do consumer prices, so companies can maintain profits.
Demand-driven inflation is a natural concept in growing economies. As demand grows faster than supply, inflation rises, causing the CPI to rise. This naturally occurs because consumers simply have more money to spend, which means they will create more demand for the supply of goods. At some point in this economic situation, supply should – in theory – increase to meet the demand for goods and services. Inflation therefore falls when the market reaches long-term equilibrium.
Cost-based inflation is the second general theory that explains inflation and any increase. According to this theory, companies incur increasing costs for the goods or services they produce. These increases can occur for a variety of reasons, such as lack of availability, increases in demand for resources, or government intervention, such as tariffs or taxes. When companies experience these cost increases, they pass the cost increase on to consumers. Thus, increases in the prices of goods and services create an increase in the CPI through the concept of pass-through costs.
Using these two main theories of inflation, it is possible to provide explanations for the variation of a nation’s prices. For example, a change in product quality can lead to an increase in the CPI. A company that refines raw materials more than before has often experienced price increases for the products. The CPI rises as higher quality prices hit the market. The introduction of new goods can also cause the CPI to rise; for example, new products in a market typically cost consumers more money, resulting in higher inflation.
Economists typically look at specific goods when creating CPI calculations. Once they discover that a price increase occurs, economists can look further to find out why the inflation has occurred. This is where the two theories above come into play, which explain the specific rise in inflation.
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