Inflation occurs when the general price levels charged for most goods and services across an economy increase. Inflation can have different causes. Two types of inflation with different causes are cost-push inflation and demand-pull inflation. The aggregate demand/aggregate supply (AD/AS) model can help illustrate the two types of inflation.
Cost-push inflation occurs when there is a decrease in the aggregate supply of goods and services in an economy, generally because of increases in the cost of production of those goods and services. As the aggregate supply is reduced, the goods and services offered become more valuable to consumers and prices rise, or are pushed up. The rise in production costs can result from price increases in any one or more of the four factors of production: land, capital, labor, and entrepreneurship. (It is assumed here that producers are already producing goods and services at full capacity. Therefore, when production costs rise, profit margins inevitably decline unless producers raise their prices, which is most often what happens in order to pass the increased costs onto consumers.)
For example, when workers negotiate higher wages to compensate for an increase in price levels for goods and services, the cost of labor to producers increases. If raw materials necessary for production become scarce, they will increase in cost; this will also occur if tariffs on necessary imported raw materials rise or the currency of the nation from which they are being imported depreciates. Tax increases can also increase the cost of production. Any or all of these costs can then be passed onto consumers through increasing the prices of goods and services, which is known as cost-push inflation.
Inflation can also occur because of increased aggregate demand for goods and services, which is known as demand-pull inflation. Increased aggregate demand can result from increased demand by companies, by buyers from other countries, governments, or households, or by any combination of these. Such increases in demand can have their origin in wage hikes, lowering of taxes, legislation instructing the government to expand purchasing, a decline in the strength of the domestic currency, the growth of foreign economies causing greater exports and the resultant scarcity of domestically produced goods and services, or growth in consumer confidence, among other causes. When this overall combined demand outpaces production, the competition among buyers for goods and services results in what is essentially a bidding war, driving prices upward. This type of inflation usually occurs in an economy that is expanding.