Inflation Explained: History, Causes, and Why Prices Only Go Up Now
Milton Friedman once said: “Inflation is always and everywhere a monetary phenomenon.”
That’s one of the most quoted lines in all of economics. And it’s a great starting point for understanding what inflation actually is, where it comes from, and why it matters so much.
Chapter 4 of Trading Economics by Trevor Williams and Victoria Turton tackles inflation head-on. There’s a lot to cover here, so I’m splitting it into two parts. This first part focuses on what inflation is, its history, and what causes it.
What Is Inflation, Really?
Inflation is the rate of change of prices. That’s it. It tells you how much stuff you can get for your money compared to last year.
If inflation is 3%, that means prices on average went up 3% from a year ago. Your money buys 3% less stuff than it did before.
Deflation is the opposite. Prices falling. Your money buys more stuff over time.
Simple enough. But the history of inflation is where things get interesting.
Prices Didn’t Always Go Up
Here’s something most people don’t realize. For hundreds of years, the UK price level barely changed. Prices went up sometimes, sure. But then they’d come back down. Inflation and deflation roughly balanced each other out over the long run.
Price falls were just as common as price rises. If you lived in 1800 and then somehow jumped to 1900, prices wouldn’t look that different.
So what changed?
The 1970s Changed Everything
Two big things happened in the early 1970s.
First, the US came off the gold standard. Before that, dollars were backed by actual gold. You could theoretically exchange your dollars for a fixed amount of gold. That kept money creation in check.
Second, the Bretton Woods system of fixed exchange rates collapsed. This was the agreement that had kept currencies stable relative to each other since World War II.
After both of these ended, money was now backed by government fiat. Basically, money has value because the government says it does. There’s no gold behind it. No hard limit on how much can be created.
And since the 1970s? Prices have only gone up. We’ve had more inflation and less deflation than at any point in recorded history.
That’s not a coincidence.
The Three Causes of Inflation
Williams and Turton break down inflation into three main types. This is a classic framework and it’s worth understanding each one.
1. Cost-Push Inflation
This happens when a key input cost suddenly spikes. The textbook example is the 1970s oil crisis. OPEC raised oil prices roughly 10-fold. Oil goes into everything. Transportation, manufacturing, heating, plastics. When oil prices shoot up, the cost of making and moving stuff shoots up too.
Businesses pass those costs on to consumers. Prices rise. That’s cost-push inflation.
It’s basically a supply-side shock. The economy’s ability to produce stuff cheaply just took a hit.
2. Demand-Pull Inflation
This is the “too much money chasing too few goods” story. The economy is running hot. Everyone wants to buy stuff. But there’s only so much stuff to go around.
When demand exceeds the economy’s capacity to supply, prices get bid up. Think of it like an auction. More bidders, same number of items. Prices rise.
This tends to happen when the economy is growing fast, wages are rising, credit is easy, and everyone feels confident about spending.
3. Built-In Inflation
This is the sneaky one. Past inflation causes future inflation.
Here’s how it works. Workers see prices going up, so they demand higher wages. Businesses see wages going up, so they raise prices. Workers see prices going up again, so they demand even higher wages. And on it goes.
This is the wage-price spiral. Once inflation expectations get embedded in the economy, inflation becomes self-reinforcing. People expect prices to rise, so they behave in ways that make prices rise.
Breaking this cycle is one of the hardest things central banks have to do.
The Monetarist View
Friedman’s monetarist school has a straightforward explanation. Inflation happens when there’s too much money supply relative to demand.
Print too much money and each unit of money becomes worth less. Prices rise.
The UK government actually tried targeting the money supply directly starting in 1976. Set a target for how fast the money supply should grow, and stick to it.
But here’s the problem. Friedman himself admitted that “the lags are long and variable.” Changes in money supply don’t hit the economy immediately. Sometimes it takes months. Sometimes years. And the timing is unpredictable.
That makes money supply a tricky thing to target. You’re steering a ship where the rudder takes an unknown amount of time to respond. By the time you see the effect, you might have already oversteered.
What UK Inflation Data Actually Shows
Williams and Turton point out something interesting about UK inflation between 1998 and 2007. During that period, inflation was surprisingly low. Why?
Goods prices were the main reason. China and India were flooding global markets with cheap manufactured goods. Plus the British pound was strong, which made imports cheaper.
But services prices told a different story. They stayed stubbornly high at 3-4%, pretty much regardless of what the economy was doing. Services are harder to import. Your haircut, your plumber, your lawyer. Those prices are set locally and tend to be stickier.
So when you looked at the headline inflation number and it seemed low, a big part of that was cheap Chinese goods masking the fact that domestic prices were still rising at a decent clip.
Import Prices and the Exchange Rate
This is a big one for the UK specifically.
Import prices and the exchange rate are closely linked to UK inflation. When the pound falls, imports get more expensive. And since the UK imports a lot of what it consumes, that feeds directly into higher prices.
Pound goes down, inflation goes up. It’s almost mechanical.
This is why currency movements matter so much for inflation watchers. A weak currency isn’t just a number on a screen. It shows up in the price of food, energy, electronics, and pretty much anything that crosses a border.
Producer Prices: The Early Warning
Producer prices measure what’s happening at the factory gate. There are two parts to this.
Input prices are what manufacturers pay for raw materials and energy. Output prices are what they charge for finished goods.
The gap between the two tells you something about profit margins. If input prices are rising fast but output prices aren’t keeping up, businesses are getting squeezed. Eventually they’ll either pass costs on (causing consumer inflation) or cut back (slowing the economy).
Producer prices often move before consumer prices. So they can act as an early signal of where inflation is heading.
Why This Matters
Understanding what drives inflation is the foundation for understanding monetary policy, interest rates, bond markets, and currency movements. Everything in economics connects back to prices one way or another.
In the next post, I’ll cover how inflation is actually measured, the difference between RPI and CPI, and how the Bank of England uses inflation targeting to set interest rates.