What Drives Inflation

Why this matters

Two bursts of inflation can look the same in the headline and come from very different places. One driven by strong spending usually comes with a strong economy; one driven by a jump in costs can come with a weakening one. The cause shapes what a central bank does next, what happens to interest rates, and which businesses can keep their margins. This lesson looks at the main causes and at how economists try to tell them apart.

Too much spending: demand

When households, businesses, and government together try to buy more than the economy can produce, sellers can raise prices without losing customers. This is demand-pull inflation, the economy-wide version of a shift in demand from Supply and Demand.

The years after 2020 had a strong dose of it. Pandemic relief put money in households' hands, and the M2 money supply, which counts cash, checking, and savings deposits, grew 40.2% in the two years to February 2022.¹ Studies cited by the San Francisco Fed found an important role for heightened demand stemming from that relief.²

Higher costs: supply shocks

Prices can also rise because producing things gets more expensive or harder: a jump in energy prices, a harvest failure, a blocked supply chain. This is cost-push inflation. It pushes prices up while holding output back, which makes it awkward for a central bank: raising rates to fight the price rise also weighs on an economy that's already being squeezed.

Measure	February 2026	May 2026
West Texas Intermediate oil, monthly average	$64.50	$102.10
CPI energy index, change since February		+19.6%
CPI all items, change since February		+2.0%
CPI excluding food and energy, change since February		+0.8%
CPI all items, 12-month change	2.4%	over 4%

Energy Information Administration and Bureau of Labor Statistics figures; CPI changes since February are seasonally adjusted.³⁴ A shock in one part of the index moved the headline sharply and the core much less. If it stays in energy, a shock like this is a one-time jump in the price level. It becomes lasting inflation if it spreads into wages and other prices.

Sorting the causes

Real episodes mix both. One way to separate them uses prices and quantities together. If a category's price and the quantity sold rise together, buyers are pushing; if the price rises while the quantity falls, supply is pinching. An analysis by the San Francisco Fed in June 2022 sorted spending categories this way and found that supply factors explained about half of the run-up in inflation at the time, demand about a third, and the rest was ambiguous.²

A 2023 study by Ben Bernanke and Olivier Blanchard came at the same episode through prices, wages, and expectations. Contrary to early concerns about overheated labor markets, it found that most of the surge that began in 2021 came from shocks to prices given wages: sharp rises in commodity prices and price spikes in particular sectors where demand ran into limited supply. Tight labor markets weren't the main driver, but their effects on wages and inflation proved more lasting than those of the price shocks.⁵

The rest of this lesson is for members

Still to come in this lesson: Money, Wages and profit margins, Expectations, the key takeaways, and 2 quiz questions with explanations.

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