The Concise Guide To Economics
by Jim Cox
32. Cost Push
One particularly popular theory among economists antagonistic to the free economy is that inflation is caused by a cost push in the form of a reduction in aggregate or total supply in the economy. In a straightforward analysis wherein aggregate supply and aggregate demand in the economy determine the price level, a reduced supply would have the effect of increasing prices in general. Thankfully though, the world we live in, including the persistent inflation, is not one of reduced supplies but ever greater production. Still, this theory is typically claimed to be applicable in the U.S. during the 1970's--the decade when Keynesian theory was revealed as clashing with actual experience.
The die-hard Keynesians claim that reduced crop yields from poor weather and the Arab oil embargo effected a supply shock on the U.S. economy, thereby driving inflation up into double digits. The problem with this theory is that it also does not fit with the facts:
Clearly, production was increasing during the 1970's while inflation was also increasing--the inflation must be explained by the demand side. In actual practice Milton Friedman's famous phrase is entirely correct--"Inflation is everywhere and always a monetary phenomenon."