What Affects Inflation

Monetary policy, specifically interest rates, is the single biggest factor affecting inflation, as it influences borrowing costs and money supply, which in turn increases or decreases inflation, such as when the Federal Reserve raised interest rates in 2018, resulting in a 2% decrease in inflation (Federal Reserve Economic Data).

Main Factors

• Money supply — an increase in money supply leads to higher inflation, as more money chases a constant amount of goods and services, for example, when the European Central Bank implemented quantitative easing in 2015, increasing the money supply by 10% and resulting in a 1.5% increase in inflation (European Central Bank).
• Economic output — an increase in economic output, or GDP, can lead to higher inflation if it exceeds the economy's productive capacity, such as when the US GDP grew by 4% in 2018, resulting in a 2.5% increase in inflation (Bureau of Economic Analysis).
• Exchange rates — a depreciation of the exchange rate can increase inflation by making imports more expensive, for example, when the British pound depreciated by 10% against the US dollar in 2016, resulting in a 2% increase in import prices (Bank of England).
• Commodity prices — an increase in commodity prices, such as oil prices, can increase inflation by raising production costs, for example, when oil prices increased by 25% in 2017, resulting in a 1% increase in inflation (US Energy Information Administration).
• Wage growth — an increase in wages can increase inflation if it exceeds productivity growth, such as when wages in the US grew by 3.5% in 2019, resulting in a 2% increase in inflation (Bureau of Labor Statistics).
• Taxation — an increase in taxes can increase inflation by raising production costs, for example, when the US introduced a 10% tariff on Chinese imports in 2018, resulting in a 1.5% increase in import prices (US Census Bureau).
• Expectations — an increase in inflation expectations can become a self-fulfilling prophecy, as businesses and consumers adjust their behavior accordingly, for example, when the University of Michigan's inflation expectations survey showed a 2% increase in expected inflation in 2018, resulting in a 1.5% increase in actual inflation (University of Michigan).

How They Interact

The interaction between interest rates and exchange rates can amplify or cancel each other, for example, when the Federal Reserve raised interest rates in 2018, the US dollar appreciated, reducing import prices and offsetting some of the inflationary effects of higher interest rates. Another example is the interaction between wage growth and productivity growth, where an increase in wages can lead to higher inflation if it exceeds productivity growth, such as when wages in the US grew by 3.5% in 2019, while productivity growth was only 1.5% (Bureau of Labor Statistics). The interaction between commodity prices and monetary policy can also be significant, for example, when oil prices increased by 25% in 2017, the Federal Reserve raised interest rates to combat the resulting inflation, which helped to reduce oil prices and inflation.

Controllable vs Uncontrollable

The controllable factors are monetary policy, taxation, and fiscal policy, which are controlled by the government and central banks, such as the Federal Reserve, which controls interest rates and money supply. The uncontrollable factors are commodity prices, exchange rates, and expectations, which are influenced by global events and market forces, such as the Organization of the Petroleum Exporting Countries (OPEC) influencing oil prices. However, even uncontrollable factors can be influenced by policy decisions, for example, a country can reduce its dependence on imported commodities by investing in domestic production, such as the US increasing its domestic oil production (US Energy Information Administration).