Understanding Two Types of Inflation: What Drives Price Increases in Today's Economy

When economists discuss inflation, they often divide it into two distinct categories based on what’s actually pushing prices higher. While central banks like the Federal Reserve aim to maintain a stable inflation rate around 2% annually as a sign of healthy economic growth, the reality is that inflation can arise from very different sources—and understanding the difference matters for investors and consumers alike.

The Supply Crunch: How Cost-Push Inflation Works

Imagine a scenario where demand for a product remains unchanged, but suddenly there’s less of it available. That’s the foundation of cost-push inflation. This type of inflation occurs when the costs of production rise significantly—whether due to expensive raw materials, higher labor costs, or supply chain disruptions—while consumer demand stays constant. The result? Companies have no choice but to raise prices to maintain their margins.

Cost-push inflation typically emerges from external shocks that companies can’t control. A natural disaster shutting down a factory, geopolitical tensions restricting resource access, government regulations increasing operational costs, or sudden changes in exchange rates can all trigger this phenomenon. Essentially, any event that reduces a company’s ability to produce goods efficiently forces prices upward.

Real-World Examples of Supply-Driven Inflation

The energy sector provides the clearest illustration of cost-push inflation. Oil and natural gas represent essential commodities that fuel modern economies—literally. Refineries depend on crude oil to produce gasoline, while power plants require natural gas to generate electricity. When global conflicts, natural disasters, or policy decisions dramatically reduce oil supplies, gasoline prices spike immediately, even though consumer demand remains relatively stable.

Recent years have shown this pattern repeatedly. Cyber-attacks targeting critical infrastructure have temporarily disrupted natural gas supplies, pushing prices higher despite unchanged weather-driven demand. Similarly, hurricanes and floods that damage refineries create temporary production shortages. With fewer refineries operational and crude oil supplies constrained, the remaining facilities must charge more simply because less product is available to meet existing demand.

The Money Chasing Goods Problem: Demand-Pull Inflation Explained

Demand-pull inflation represents the opposite scenario. Rather than a supply problem, this inflation type emerges when aggregate demand—the total amount consumers, businesses, and governments want to buy—exceeds available supply. Economists capture this dynamic with a memorable phrase: “too many dollars chasing too few goods.”

Demand-pull inflation typically flourishes during strong economic periods. As employment rises and workers earn higher wages, they spend more aggressively. Simultaneously, loose monetary policy (low interest rates, increased money supply) puts more purchasing power in circulation. When this increased spending power meets limited goods availability, prices rise as consumers and businesses compete to secure products.

This doesn’t just affect consumer goods. Government stimulus programs injecting money into the economy, or central banks maintaining artificially low interest rates, can both fuel demand-pull inflation across entire sectors.

Contemporary Examples of Demand-Driven Price Increases

The post-pandemic economic recovery illustrates demand-pull inflation vividly. Following lockdowns in early 2020, vaccine distribution accelerated significantly by late 2020 and into 2021. As vaccination rates climbed and economies reopened, pent-up consumer demand exploded. People wanted to travel again, upgrade homes, purchase vehicles, and consume goods unavailable during lockdowns.

However, factories and supply chains couldn’t respond fast enough. Inventories remained depleted for months. Employment surged, giving consumers more disposable income precisely when goods remained scarce. The result was classic demand-pull inflation: gasoline prices rose as more workers commuted to offices; airline and hotel prices climbed as travel demand revived; housing prices skyrocketed as low interest rates encouraged home purchases while construction couldn’t keep pace; lumber and copper prices soared to historic levels as new construction boomed.

The underlying issue wasn’t that production costs increased—it was that consumers possessed more purchasing power than available supply could satisfy.

Key Takeaway: Different Inflation Types, Different Solutions

Understanding whether inflation stems from supply constraints or excess demand matters considerably. Central banks may respond differently depending on inflation’s source. Cost-push inflation driven by supply shocks may require a different policy response than demand-pull inflation fueled by excessive spending.

For investors navigating inflationary environments, recognizing these distinctions helps explain why different sectors experience price pressures at different times, and why the inflation outlook remains crucial for asset allocation decisions across traditional markets and emerging sectors like digital assets and CA markets.

The distinction between these two inflation mechanisms remains as relevant today as when economists first formalized these concepts.