Inflation spirals out of control when people demand pay raises because their money isn't going as far because of sudden price increases. If prices go up too quickly, they can disrupt an economy's ability to function normally. People in "hyperinflation" tend to spend their paychecks as soon as they come in because waiting even hours results in higher prices.

As a result, governments typically employ interest rate policies and inflation targets to limit price increases to acceptable levels. When widespread anticipation precedes a small amount of inflation, the result is usually benign. Inflation within the United States should average 2% per year, according to the Federal Reserve.

However, since the spring of 2021, price increases in the United States and elsewhere in the developed world have been significantly outpacing inflation. The threat of a global slowdown and even a recession in some countries in 2023 is a direct result of the high inflation that has prompted many central banks to begin raising interest rates. One must first understand the fundamentals of inflation and its causes before being able to make sense of the actions being taken by central banks and their potential consequences for businesses.

Why does inflation happen?
Inflation can be traced back to an imbalance between demand and supply. Bernanke, a former Fed chair, and Andrew Abel, a professor of macroeconomics, write, "Inflation occurs when the aggregate quantity of goods demanded at any particular price level is rising faster than the aggregate quality of goods supplied at that price level."

But why does demand exceed supply in the first place? A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know by David Moss provide an overview of the three pillars of macroeconomics that can explain why this might occur. The book is organised by Moss according to the three concepts of output, money (how much cash is in circulation), and expectations (what people think will happen next). All three contribute to inflation.

Shocks to the supply of a necessary economic input, such as energy, are a common cause of inflation. For instance, if a war causes a significant number of oil fields to stop producing oil, the cost of energy will rise. Since energy is a necessary component of virtually every product, its rising cost drives up the cost of those products as well. The term "cost-push inflation" is commonly used to describe this phenomenon.

If there is less of a product available, the price should rise, demand should fall, and a new equilibrium would be reached. Real life is more intricate than that. It is possible that a supply shock could cause prices to rise steadily because there aren't many viable alternatives. Alternatively, this could be because consumers are readjusting their expectations for future inflation in light of the initial price hike or because of the ambiguity surrounding the end of the supply shock.

There is also the demand side of the money-supply equation. Moss explains that inflation is typically brought on by a rise in the money supply. He says that when people have more money, they start to see purchases as investments rather than impulse purchases. The rising demand from consumers will only lead to higher prices and a further acceleration of inflation if the supply of goods and services has not also increased. "Too much money chasing too few goods" is a common phrase used by economists to describe the causes of inflation. This phenomenon is sometimes called "demand-pull inflation."