Why Prices Are Rising: Understanding the Drivers of Inflation
March 2023
Inflation: A Constant Threat to the Economy
Inflation is undoubtedly one of the most pressing economic concerns today. The sustained rise in prices has set off alarm bells, and for good reason: our money loses value, reducing our purchasing power. However, inflation is not a new phenomenon. It has existed throughout history, fluctuating with economic expansion and contraction cycles. One of the primary objectives of central banks, such as the European Central Bank (ECB) and the U.S. Federal Reserve (FED), is to keep inflation under control through tools like interest rates.
But what exactly is inflation, and why does it occur?
What Is Inflation?
In economic terms, inflation is the widespread and sustained increase in the prices of goods and services over a given period. When prices rise, the purchasing power of money declines, meaning that the same amount of money buys fewer goods and services.
Causes of Inflation
Inflation occurs when the demand for goods and services exceeds the ability to produce or import them, leading to price increases. In other words, when consumption of a particular product rises but supply remains limited, prices naturally go up.
This was precisely the case in 2020 during the global health crisis. Many companies halted or significantly reduced production, leading to product shortages and so-called bottlenecks—situations where certain industries struggled to scale up production. This supply disruption, combined with strong demand, created inflationary pressures.
From the demand side, consumer spending surged, particularly in physical goods. Before the crisis, economic structures were more adapted to service-based industries rather than goods production. The sudden shift in demand from services to goods created production constraints, as companies were not equipped to manufacture the products consumers now wanted.
Another key factor is the behavior of businesses in times of scarcity. When entrepreneurs fear running out of supplies, they tend to increase their purchases to secure raw materials for production. If many companies act this way, supply chains become even more strained. A similar phenomenon was seen at the household level with the toilet paper shortage in North America—panic buying led to actual shortages.
Additional Inflationary Pressures
Beyond supply and demand imbalances, other factors contribute to inflation. One significant aspect is the global energy transition. Cleaner energy sources, while more sustainable, are also more expensive. These higher production and distribution costs ultimately get passed on to consumers.
However, the most influential factor behind recent inflation is monetary and fiscal policy. In response to the 2020 crisis, governments implemented massive stimulus packages to boost spending. This led to an excess money supply in the economy, overheating demand while supply remained constrained. In simple terms, the formula for inflation could be:
Rigid supply + explosive demand = rising prices
The Impact on Wages and Public Debt
In Spain, wages are expected to rise by only 1.5% under collective agreements, while inflation hovers around 5.5%. This means real wages will decline by 4%—one of the sharpest drops of the 21st century.
Public debt is another critical issue. Many countries have accumulated excessive debt levels. In Spain, for example, public debt has surged from 15% of GDP in 1980 to 118% today—meaning the country owes 18% more than its annual income. As interest rates rise, servicing this debt becomes even more expensive.
How does this affect the average citizen? Governments often respond by increasing tax revenues through higher VAT, income tax, corporate tax, inheritance tax, wealth tax, and other levies. Ultimately, this reduces the amount of money in people’s pockets, further impacting their purchasing power.
Inflation is a complex and multifaceted issue, but understanding its causes and consequences is crucial to navigating its effects on both individuals and the broader economy.
Public Debt of Spain
Spanish public debt as a percentage of GDP
And the situation is not so different in other countries around the world. In the United States, public debt is equivalent to 128% of the country's GDP, something that is repeated in countries like France and Italy.
Public debt in some countries of the world
Public debt to GDP
A Bit of History: Lessons from the Past on Inflation and Economic Overheating
While history does not repeat itself exactly, it often follows remarkably similar patterns. Inflationary cycles have appeared time and time again, triggered by a mix of economic overheating, external shocks, and policy missteps. Understanding these historical precedents is crucial to navigating today’s inflationary challenges.
Historically, three major factors have contributed to inflationary booms:
Cheap Credit – When borrowing costs are low, businesses and consumers take on more debt, fueling increased spending and investment. This can lead to rapid economic expansion, but if left unchecked, it can also create asset bubbles and excessive demand that push prices higher.
Technological Innovations – Breakthroughs such as the Industrial Revolution, the rise of automobiles, the internet boom, and artificial intelligence have all fueled economic optimism and expansion. While technological advancements drive long-term economic growth, they can also create speculative bubbles, as seen in the dot-com boom of the late 1990s.
Unmeasured Optimism – Periods of economic growth often lead to excessive confidence in the future, encouraging riskier investments and speculative behavior. Investors and policymakers may underestimate risks, assuming that the boom will continue indefinitely. This can lead to an overheated economy, followed by sharp corrections.
The 1970s Inflation Crisis: A Key Historical Parallel
One of the best historical comparisons to today’s inflationary pressures is the crisis of the 1970s. That decade saw a combination of supply shocks, policy miscalculations, and external factors that pushed inflation to dangerously high levels.
Oil Shocks and Supply Bottlenecks – The 1970s were marked by two major oil crises: the 1973 oil embargo (triggered by OPEC in response to geopolitical tensions) and the 1979 Iranian Revolution, which severely disrupted global oil supply. The sharp rise in energy prices led to cost-push inflation, meaning businesses faced higher production costs, which were passed on to consumers in the form of higher prices.
Loose Monetary Policy – During the early 1970s, the Federal Reserve maintained low interest rates and expanded the money supply to stimulate growth. However, this excess liquidity, combined with the oil shocks, fueled inflation instead of stabilizing the economy.
Wage-Price Spirals – As prices rose, workers demanded higher wages to keep up with the cost of living. Businesses, in turn, increased prices to cover rising labor costs, creating a vicious cycle of persistent inflation.
Double-Digit Inflation – By the late 1970s, inflation had soared to 12%–15%, far above the historical average of 3%–4%. This led to declining real wages, eroding consumer purchasing power, and economic stagnation.
US inflation 1970−2023
The Role of Central Banks: Then and Now
In response to runaway inflation in the 1970s, the Federal Reserve, under Chairman Paul Volcker, implemented aggressive interest rate hikes. The Federal Funds Rate was raised to nearly 20% by the early 1980s, a drastic measure that successfully curbed inflation but also triggered a sharp recession. The lesson from this period is clear: failing to act early on inflation can lead to much harsher consequences later.
Fast forward to today, and central banks face a similar dilemma. Inflation, fueled by supply chain disruptions, rising energy costs, and massive fiscal stimulus in response to the COVID-19 pandemic, has led institutions like the Federal Reserve and the European Central Bank (ECB) to raise interest rates in an attempt to cool the economy. The challenge is balancing inflation control with avoiding a severe economic downturn.
US Interest Rates 1970−2023
Modern Parallels: Is History Repeating Itself?
While today’s inflationary environment is different from the 1970s in some ways, there are undeniable similarities:
Supply Chain Disruptions – Just as the oil crises of the 1970s restricted supply, today’s global supply chain bottlenecks (exacerbated by the COVID-19 pandemic and geopolitical tensions) have driven up prices for goods and raw materials.
Energy Price Shocks – Rising energy costs due to the global transition to clean energy, geopolitical conflicts, and supply shortages are reminiscent of past oil shocks.
Loose Monetary Policy and Fiscal Stimulus – Massive government spending and historically low interest rates from 2020 to 2022 flooded the economy with liquidity, contributing to overheating demand—just as excessive monetary expansion did in the early 1970s.
Rising Wages and Price Pressures – In many countries, labor shortages and rising costs of living have led to wage increases, further fueling inflation.
Key Takeaways from History
The lessons from past inflationary episodes highlight several critical points:
Inflation is difficult to control once it takes hold – The longer inflation persists, the harder and more painful it becomes to rein in. Delayed action in the 1970s led to drastic interest rate hikes and a recession.
Central banks play a crucial role – A strong, proactive monetary policy is essential to prevent inflation from spiraling out of control.
Energy and supply chain resilience are key – Reliance on volatile energy markets and fragile supply chains can lead to inflationary shocks. Diversification and investment in infrastructure are necessary to mitigate risks.
Public and business sentiment matters – Inflation expectations can become self-fulfilling. If businesses and consumers expect prices to keep rising, they adjust behavior accordingly (raising prices and demanding higher wages), reinforcing inflation.
Final Thoughts
While today’s inflationary environment has unique challenges, history provides valuable lessons. The 1970s taught us that failing to address inflation early can lead to severe economic consequences, including deep recessions and financial instability. Policymakers today must strike a delicate balance between cooling inflation and maintaining economic growth, all while navigating supply disruptions, rising energy costs, and global uncertainties.
Understanding the past helps us make informed decisions about the future. Inflation remains one of the most complex economic challenges, but with decisive action and careful policy management, its long-term effects can be mitigated.