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A Review of Economic Theories of Inflation

Authors: Daria Kachanovich, Josephine Miller, Katherine Miller, Sara Shah, and Arya Shinoj

Mentor: Dr. Gerard Dericks (PhD, London School of Economics). Dr. Dericks is currently the director of the Center for Entrepreneurship and Economic Education at Hawaii Pacific University.



There is perhaps no economic subject more important for the maintenance of civilization than inflation, and yet there remains much confusion in popular as well as academic circles as to its causes. This review surveys the existing academic literature on the causes of inflation, identifying six separate theoretical causes. While few definitive conclusions are reached in the literature, it is noted that these inflation factors can be categorized as belonging to either demand-side or supply-side determinants of inflation. Moreover, the introduction of this supply and demand theoretical framework suggests that supposedly opposing theories of inflation are in fact complementary, and therefore an inclusive rather than adversarial approach to inflation research is needed.



Inflation is known to be a cause of many unfavorable economic outcomes including the loss of savings, disruption of price coordination, wealth inequality, arbitrary wealth transfers, and perhaps most troubling, political instability. Paldam (1987) for instance in a study of Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay and Venezuela found that, “…few regimes survive a spell of hyperinflation” (p.143).

It is concerning that after being held to low levels for several decades in western countries, inflation has recently spiked globally. But what causes inflation? Both popular and expert opinion appears divided on this issue. Within the past 18 months, Jerome Powell, the head of the U.S. Federal Reserve has gone from stating that the inflation currently being experienced will be ‘transitory’ and dissipate quickly, to desperately raising the Federal Funds Rate faster than at any time in the U.S. Central Bank’s history. How can it be that despite thousands of research papers written on this subject the most powerful and influential monetary institution in the world could get its predictions so wrong? Likewise the general public seems perplexed as to why inflation is currently happening, receiving its opinions from a similarly flummoxed media.

This paper provides an overview of the different theories of inflation discussed in the economic literature including the quantity theory, demand-pull theory, cost-push theory inflation expectations, fiscal theory of inflation, economic output, and taxation. Furthermore, we provide a useful overarching framework for how these theories separately and jointly relate to changes in the price level.

Literature Review


Inflation means an increase in the general or average price level of final goods and services. There has been a profusion of theoretical explanations for the causes of inflation including; the quantity theory, demand-pull, cost-push, the taxation theory, the fiscal theory, and the theory of inflation expectations. This apparent multiplicity of theoretical explanations for changes in the purchasing power of money can be distilled to the basic determinants of all prices, supply and demand. A contribution of this review is to not only survey the existing corpus of literature on the causes of inflation, but to classify these various explanations into these two fundamental antecedents of all prices – namely, supply-side determinants of inflation, and demand-side determinants of inflation.

Supply-side determinants of inflation

The Quantity Theory

Turning first to supply-side determinants of inflation, the money supply theory of inflation is perhaps the oldest theory of inflation. It is believed to have been first proposed by Nicolaus Copernicus in 1517. In the present day this theory has taken on the moniker of ‘the quantity theory of money’, and this is how it is generally referred to in modern textbooks. Proponents of this theory such as the celebrated economist Milton Friedman, have been labeled ‘Monetarists’ for the contention that inflation is predominately caused by expansions in the money supply. Milton Friedman is widely known for his famous quote that, "Inflation is always and everywhere a monetary phenomenon.” Why did he state this? This is because under a fiat currency regime where money cannot be redeemed for any commodity - the regime exclusively practiced by all organized governments today, it is the case that the money supply is the most mutable determinant of the price level, and therefore has historically had the most influence on it.

Large scale surveys of money supply growth and inflation across multiple countries over several decades show a significant effect of money supply growth with high correlations. McCandless and Weber (1995) survey 140 countries over the period 1960-1990 and find a correlation between the rate of M2 money supply growth and the inflation rate of 0.95 (out of a total possible 1.00).

Source: McCandless and Weber (1995).

A follow-up study by Hanke et al. (2022) investigates the subsequent period from 1990-2021 and extends the same analysis to 147 countries, and finds a similarly high correlation of 0.94. These strong correlations and their stability across geographies and over multiple decades demonstrate that this relationship is robust.

Source: Hanke et al. (2022).

While the majority of papers find significant effects of increases in the money supply and inflation rates, a number of studies fail to report a significant relationship. For instance, Modigliani and Papademos (1975) found that money growth had little explanatory power with regard to inflation once the level of unemployment was controlled for. Another more recent study by Del Negro et al. (2020) found that the money supply was not the principal driver of inflation, as evidenced by the lack of inflation following the quantitative easing (QE)-based monetary expansion during the Great Recession. However, Werner’s (2005) quantity theory of disaggregated credit which separates credit created for consumption with credit created for asset purchases effectively addresses this issue. According to Werner, it is only credit created for consumption which generates inflation, whereas credit created for asset purchases (i.e. the sort of QE that the Federal Reserve practiced during the Great Recession) tends to stay in assets markets, and therefore has little effect on the Consumer Price Index.

Demand-side determinants of inflation

Unlike the money supply which is a relatively concrete and singular variable, money demand has been separated by researchers into various categories. These include demand-pull theory, the theory of inflation expectations, the taxation theory, and the fiscal theory of inflation.

Demand-pull theory

Demand-pull inflation happens when there is an increase in aggregate demand, caused by factors such as an expanding economy, increased government spending, or economic growth overseas. It is categorized by the four sections of the macroeconomy: households, business, government, and foreign buyers. Demand-pull inflation does not have to be caused by policy. As the prominent political commentator John Maynard Keynes would say, the “animal spirits” of society could become more positive with regards to the future, resulting in more current spending, and rising prices (Meyer, 2022).

Keynes (1940) introduced demand-pull inflation via a model of the economy where price rigidities combined with an unexpected increase in aggregate demand led to an increase in the price level. This model was later taken up by a number of economists including G. Ackley, S. Maital, A. Smithies, and J.A. Trevithhick. These and other so-called ‘Keynesians’ treat demand factors as the primary cause of inflation. However, this work is largely theoretical and scant empirical analyses of the real world exist. The papers identified in this review adopting an empirical approach fail to find an effect, and others such as Jorgensen and Ravn (2018) find that increased demand in the form of government spending actually reduces inflation. Still other authors may blur the lines between demand-pull inflation and the quantity theory. Barth and Bennett (1975) for instance make the inference that increases in the money supply translate into an increase in demand, and as such, this and similar papers would more correctly be classified as belonging to supply-side inflation theories rather than demand-pull inflation. The confusion here arises from the fact that the money supply in part determines the demand for goods, and this is the ‘demand’ to which Barth and Bennett refer.

Inflation expectations

Inflation expectations refer to the public's belief about what inflation will be in the future. Inflation expectations have a contemporaneous impact on the economy since these will affect people’s present economic behavior. When a person has high inflation expectations, demand for goods (and to get rid of cash) increases, leading sellers to increase their prices, thereby contributing to still higher rates of inflation. In this sense, when inflation expectations are high, actual rates of inflation are impacted.

Empirical studies of inflation expectations have found it to be one of the more important determinants of inflation. A literature review by Kapoor and Kar (2003) for instance found 514 papers over the past forty years using this variable as an determinant of inflation. In studies regarding the inflation expectations in households, it has been suggested that respondents in inflation expectations surveys usually act consistently with the expected utility theory (Armantier et al., 2013). There is a strong correlation between expected inflation and realized inflation, though that correlation may weaken over short periods of time, such as during the Great Depression, the Great Inflation, and the Great Recession. This illustrates the importance of policy regime changes in inflation realization (Binder and Kamader, 2022). During the Great Recession specifically, inflation expectations were much lower over long-term timeframes while higher over short-term timeframes, and the long-term rates were closer to realized inflation (Church, 2019).

Fiscal theory of inflation

The fiscal policy theory of the price level states that inflation results when people do not expect the government to fully repay their debts. More precisely, prices adjust so that the real value of government debt equals the present value of taxes less spending. This theory is directly related to the now discredited Real Bills Doctrine. The Real Bills Doctrine is essentially a variation of the fiscal theory, as it relates to the credibility of the issuing institution, in particular that issuing institution will be able to redeem notes issued against some commodity. However, this theory has been disproved since the permanent abolishment of gold and silver standards. As, according to this theory, all fiat money should have then become worthless, which has not been the case for 90 years in the United States.

However, fiscal policies have been shown to have a direct impact on inflation. Sujaningsih et al. (2012) finds that “the negative effect of positive government spending shock to the inflation can be explained by the possibility of greater multiplier effects of government spending on investments (including infrastructure) than routine expenditures” (p. 24).The spending that the government does on infrastructure is predicted to lower the costs of the distribution of goods and services, therefore, contributing to the decline in inflation. On the other hand, the effect of an increase in inflation due to a positive tax shock could possibly be triggered by an increase in production costs as a response of tax costs increasing.

Similarly, a more recent study by Cochrane (2022) shows how the government fiscal policy to increase debt during Covid-19, led to inflation. A data set that this article used was a table that represented Federal Debt, Reserves, and M2, 2019-2021 (billions of dollars). This table demonstrates how the government, in response to Covid-19, created new bank reserves out of trillions of dollars, which as a result caused inflation just a year later. The cause of inflation was due to the Treasury borrowing $3 trillion of new debt, which the Fed bought in return for new reserves worth $3 trillion. Then, the treasury borrowed another $2 trillion and sent more checks, causing the federal debt to rise by almost 30%. This paper answers a series of questions such as, why we are seeing inflation, why a fiscal helicopter drop of $5 trillion into the public’s bank accounts produces inflation, and if inflation will continue. The study talks about how depending on future fiscal and monetary policies, the future of inflation will be impacted.

Another aspect that may affect the future of inflation is if people believe that new debt comes with a commitment to repay it. The Fed borrowed trillions of dollars of money during Covid-19 which ultimately led to inflation. Additionally, when a country is in a lot of debt, it reduces the amount of investors willing to invest there. This is due to the fact that when a country has low credibility and is heavily in debt, investors view its economy as riskier.

Bossone (2019) presents a theoretical model showing that when countries have low credibility and are in debt, actions including investors holding the economy to a smaller budget constraint and policies directing growth causes inflation. In contrast, high credibility and low-debt creates non-inflationary policies. But, government policies are also influenced by the political stability of the country. The data presented by Edwards and Tabellini (1991) shows a different behavior of inflation in least developed countries (LDC) and the authors test two hypotheses to support this difference; “First, political instability and polarization determines the strength or reputational incentives, and hence ultimately the government credibility. Second, political instability determines the rate of time preference of society as a whole, and hence matters for any collective intertemporal decision” (p. 22-23).

However, there is an extension of this theory, suggested by the work of Alesina and Drazen (1989) and Aizenman (1990). Aizenman stated “political institutions and in particular the degree of political cohesion influence a society’s capacity to make decisions and to change the status quo in the face of adverse economic circumstances” (p. 23). In this case, expectations of future solvency also matter.

Economic Output

Economic output is a measure of all the goods and services produced in a given time period and sold to final consumers. It is a measure of the total production of an industry and is used to gauge the performance of the economy. Output is an important indicator of economic growth and can be used to compare the performance of different industries.

The economic output of an economy has been shown to directly affect the level of inflation but it is rarely analyzed on its own. Rather, when included, it is typically added as a refinement to the quantity theory of money. In particular, related to the quantity of money theory is the quantity of money per unit of output theory of inflation. This theory posits that inflation is not solely the result of increases in the money supply alone, but is actually a product of increases in the ratio of the money supply to the output of real goods and services. In effect, inflation occurs when more money chases fewer goods. This is indeed the relationship stipulated by Irving Fisher in his famous quantity equation, whereby;



M = the money supply V = the velocity of money P = the average price level Q = the quantity of economic output

A result of this equation is that increases in the money supply (M) do not necessarily lead to increases in the price level (P). We can see this directly where if M were to increase, to keep the equality, Q could rise in place of P. Similarly, if output (Q) were to fall holding the M and V constant, then in order for the equality to hold, a rise in the price level is required. Indeed, Milton Friedman’s full quote on the matter mentioned earlier is in fact, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output [emphasis added]” (1970, p.24).

Empirical studies of the money supply per unit of output theory have been shown to have superior explanatory power over measures of the money supply alone. For instance, Schwartz (1973) found a correlation between changes in the money supply per unit of output of 0.97 compared to 0.95 and 0.94 respectively in the studies by McCandless and Weber (1995) and Hanke et al. (2022), mentioned earlier.

Source: Schwartz (1973)

Such results show that the money supply per unit of output variable used by Schwartz is slightly superior to the money supply alone as an explanatory factor for inflation.

Another way that output can be observed to affect inflation is indirectly through increased costs. Cost-based inflation occurs when there is a decrease in the aggregate supply of goods and services, caused by an increase in the scarcity of inputs to production such as raw materials or labor. For instance, Tatom (1977) and Jorgenson (1982) concluded that the high levels of inflation experienced contemporaneously were at least partially attributable to the heightened energy prices arising from reduced OPEC oil production. In the shipping sector, Furceri et al. (2022) examined the impact of global shipping cost movements on inflation from 1992 until Covid-19 disrupted global supply chains leading to shipment delays and soaring shipping costs. In particular, they found that a one-standard-deviation increase in global shipping costs increases domestic headline inflation by around 0.15 percentage points, with the effect building up over 12 months. The strength of the pass-through from shipping costs to domestic inflation depends on the import share of domestic consumption, the degree of economic integration into global supply chains, and the strength of the monetary framework, with larger impacts in emerging and low-income countries that tend to have weaker monetary frameworks, and highest of all among small island countries that rely heavily on imported goods.

Another cause of cost push inflation that contributes to economic output is market power inflation. Essentially this is when producers are incentivized to strategically reduce output in order to raise prices for their benefit. In the 1950s and 1960s economists frequently referred to the increasing power of unions as having the potential to bring about inflation (Schwarzer, 2018), though this position was criticized by Friedman (1968). Ackley (1966, p. 71) emphasized that it is market power as such, and not necessarily a rise in market power, that is important in causing inflation, positing the following scenario. An increase in demand that strengthens a producer’s ability to realize the desired monopoly price would in its wake increase costs for other producers, who would also raise prices in order to restore their desired profit margins.

However, there are also papers that have found little to no effect on inflation from economic output. Selden (1959), for instance, argues that cost-based explanations of inflation have been ‘exaggerated’, and Stein (1982) reported that once past money growth is considered, the level of unemployment (effectively a proxy for output) does not affect the rate of inflation.


Taxation has been shown to have an effect on inflation. Taxation can be used to influence consumer behavior, which leads to inflationary pressures. By reducing citizens’ purchasing power, taxation may lower aggregate demand, and assuming no equivalent increase in government spending, this may simultaneously lower inflation pressures (Pitchford and Turnovsky, 1976). In other words, an increase in tax will lead to a deflationary effect on demand. This follows traditional macroeconomic theory. On the other hand, some authors have pointed out how tax increases would increase inflation through higher costs, because taxes increase market prices (Smith, 1952), or through reducing the output of goods and services as a result of the deadweight losses of taxation.

However, not all studies find that taxation has an effect on inflation. For instance, a study of Nigeria’s taxation policy found that when the government increased taxation this did not have a causal relationship with inflation (Adegbite, 2019). It can therefore be said that the economic literature has not found a consensus on whether taxation has a relationship with inflation, as some studies find that inflation can have either a positive or negative relationship, but others find there is a lack of an effect.



As in much empirical work in economics, we find that the determinants of inflation appear to be situational. Some studies of a specific determinant have found an effect in a particular scenario, but other studies of the same variable did not in another. We often observed in fact that researchers would reject a theory if a variable did not fully explain the observed inflation on its own, or if it did not manifest exactly according to a theorized mathematical relation, such as proportionality. This is reminiscent of the criticism that Big Tobacco manufactured against the causal role of smoking in lung cancer. Here paid researchers would note that smoking alone didn’t fully explain the incidence of lung cancer, and then claim that smoking therefore couldn’t be ‘the cause' of lung cancer. But of course, it is a logical error to assume a priori that lung cancer, like inflation, can have only one cause, and therefore that if you haven’t found a single variable that can fully explain its incidence, then your search has been a failure. Rather, it should be expected that there will be a myriad of variables that will matter and possibly influence one’s estimates. Experiments where one can control for all other potentially confounding influences are generally not possible when studying macroeconomic phenomena like inflation, and so perhaps critics may have been too quick to denigrate correct theories that did not always and everywhere perform to an experimental standard.

Another surprising result from this review paper is that the literature does not appear to have put forward an overarching theory for how each determinant of inflation fits into a broader framework of its causes. Without this perspective it is difficult to understand where any given theory may relate to others. The papers identified on the fiscal theory of inflation for instance did not indicate that this was effectively a demand-side theory.

Going forward, researchers would do well to recognize that, like all prices, a broad average of prices such as inflation must likewise be determined by supply and demand. In this case, the supply of money and the demand for money. Therefore all legitimate determinants of inflation will be able to be conceptually categorized as either a component of aggregate demand or aggregate supply. In this paper we have separated theories of inflation according to these two broad categories. We found that a singular theory is generally sufficient for the supply-side, namely the quantity theory. But that demand-side theory has been separated into a myriad of different factors that may affect demand.



Perhaps no topic is more central to the study of economics than that of inflation. Nevertheless there appears to be much confusion in popular as well as academic circles as its causes. Monetarists tout supply as the cause of inflation, whereas Keynesians focus on demand. Unsurprisingly, both sides can point to historical instances where inflation did or didn’t move as expected under their particular theory. To address this apparent conflict, this review has surveyed the existing literature on the causes of inflation. This review identified six separate causes of inflation, and has recognized that each can in fact be categorized as belonging to either demand-side or supply-side determinants of inflation.

We are therefore able to recognize that the Monetarist and Keynesian debate as to whether the supply- or demand-side determines the price level is in fact a futile question. Like all prices, the price level will be co-determined by both supply and demand factors, and it is meaningless to examine the effect of either in isolation. Rather, supply and demand must always be examined jointly. Only when viewed from this holistic price-determination framework does a complete picture of the causes of inflation emerge, as well as the source of the present-day confusion stemming from focusing on only one side of this coin, so to speak. In reality, both Monetarist and Keynesian theories are equally wrong and equally correct in the sense that, while they both comprise essential components of inflation, to focus exclusively on either is an inherently flawed theoretical framework. Happily, the way forward to resolving the now decades old conflict between the Monetarists and Keynesians is simply to recognize that there isn’t one.



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