What causes inflation? We all know what it generally means when inflation increases: higher prices for everyone. But why does this happen?
This guide will tell you everything you need to know about its pros, and cons, who benefits from it, and what you can do to get ahead of it. Keep reading to see how you can protect your family's wallet.
What Is Inflation?
Inflation is when the money you use loses its purchasing power. It means the dollar you used a few years ago won't buy as much today. This usually happens when either the supply of money has increased or when prices of products surge.
Naturally, inflation has a terrible reputation for everyone from investors to policymakers to the average consumer. Just about everything rises in price, from gasoline to groceries to cars.
According to research by Penn Wharton, the average U.S. household spent
$3,500 more to buy the exact same goods and services as it did in 2019-2020 due to inflation!
This is a real concern for most citizens because it means the money you're saving right now won't be worth as much tomorrow. It can lower your ability to purchase and even your ability to retire.
As we speak, the US inflation rate has risen to 8.6% — a 40-year high
How Does Inflation Work?
Inflation is caused by the costs of normal goods and services continually increasing over a long period — it doesn't happen overnight.
It's also a bit more complex than just seeing prices rise. For example, let's say you go grocery shopping and see a carton of milk for $2. Then next month, you come back to see it costs $4. This price jump doesn't account for inflation alone, since prices and financial systems are in constant flux.
It's not considered inflation by economists until there are rising prices across several different products and services.
How Does Inflation Start?
The costs of products and services have increased steadily in the U.S. every year since World War II, but that's mostly because the economy has grown larger.
But several different factors drive prices and inflation up in the economy. And if we already know how it starts...why can't we prevent it?
Let's take a look at the causes of inflation.
What Causes Inflation?
Typically, various factors in the economy drive inflation.
Here are some of the most important factors that you should be aware of:
The Growing Economy (Demand-Pull Inflation)
When the economy grows stronger and larger, unemployment typically drops, and wages rise. Because of this, more people find that their wallets get bigger. They are in turn ready to spend this newfound money on not only necessities but luxuries.
This creates a higher demand for products. That higher demand allows suppliers to increase their prices, which then leads to more jobs and more money in circulation.
When you look at inflation from this angle, it's a good thing.
The Federal Reserve actually wants there to be some inflation (around 2%-3% in the consumer price index) as it is a vital sign that the economy is working well.
Let's look at examples of inflation. Let's say The Beatles are in concert. Because there's a limited amount of seats and the demand for the show is much higher than capacity, the price of the tickets would skyrocket.
Cost-push inflation occurs when prices of goods and services increase because the cost of raw materials and labor wages goes up. These costs are usually passed down to the consumers through higher prices.
For example, let's say that a car engine uses a very specific type of natural compound that is only found in one region in the world. If that region suddenly has a shortage of the compound, the price would rise significantly. Car manufacturers would in turn pass those price increases to customers.
Increased Money Supply
Money supply refers to the total amount of money in circulation. If the supply of money increases faster than the rate it is being produced, this can also result in inflation. This is because there are too many dollars trying to purchase too few products.
Devaluation refers to the adjustment of a country's exchange rate. This typically results in a lower value for a country's currency
This leads to the exports sent out by the country becoming less expensive, which encourages other countries to purchase more of these "sale-price" goods. Imported items for the devalued country also become more expensive.
Although rising wages might sound mostly positive at first glance, it can also add to inflation.
Wages are an extra cost for businesses. If those wages rise by a large amount, the businesses will have higher costs that they will either have to pass on to the consumer or make significantly less margins.
Economists are mixed on wage increase's impact on inflation, though. Some believe that increased wages result in cost-push inflation because of the higher cost to run a business. Others believe that higher wages help increase demand, which offsets the rise in prices.
Policies and Regulation
Government policies can also have a significant effect on inflation rates. For example, when the government reduces taxes
for certain products, it can increase demand, which can lead to higher prices if there isn't enough supply.
Another example would be something like building regulations or rent stabilization policies. These can pass on costs to residents and artificially lower the amount of housing available.
What Is Causing Inflation in 2022?
After the pandemic, several factors combined rapidly increase inflation. Prices surged due to labor shortages and supply chain bottlenecks.
Then, the demand for activities for people exiting quarantine dramatically rose, such as traveling, flying, or attending sports and concerts. People armed with stimulus checks and saved money further increased prices.
On the other hand, the Ukraine-Russia conflict made the situation worse as oil prices soared to record heights, as well as other commodities like corn and wheat.
This "perfect storm" of events has caused one of the worst inflation rates seen in decades.
Advantages and Disadvantages of Inflation
Inflation has far-reaching consequences, both good and bad.
Let's take a look at how they affect both the consumers and the economy as a whole.
Disadvantages and Consequences of Inflation
We've covered several reasons why inflation hurts the economy. Here's a list of other disadvantages to inflation:
- Inflationary growth tends to lead to a series of damaging boom and bust economic cycles
- It lowers people's purchasing power
- It tends to lower investment and long-term economic growth
- It makes the economy uncompetitive, especially for countries that see the value of their currency decrease
- It reduces the value of savings for the average consumer
- It disproportionately hurts the poor
- It raises interest rates
Additionally, high inflation can lead to a painful recession afterward, like what happened in the U.S. during the stagflation in the 1970s.
Advantages of Inflation
Inflation rising isn't all bad. There are also some benefits of inflation, including:
- More dollars means more spending, which equals more demand and higher production — theoretically healthy economic growth
- It makes it easier for debtors to repay loans with less valuable money than the money borrowed
- Modern inflation allows adjustment of real wages and prices
On the bright side, inflation is still much better than deflation. A fall in prices can increase the debt burden and force people to spend and invest less. Deflation was one of the biggest factors of the Great Depression in the 1930s.
Who Benefits From Inflation?
While most consumers can't expect any benefits from inflation, investors can actually benefit if they hold their assets in various markets that are affected by inflation.
- For example, oil company investors will see a rise in their stock prices if the cost of oil continues to increase
Companies can also benefit from inflation if they charge more for their products because there is a higher demand for their goods.
- For example, if the economy is healthy and there is a high demand for housing, companies that build homes can charge more for homes
Also, businesses can withhold supplies from the market on purpose, which would let prices increase to a level that they want them to. Basically, businesses can benefit from inflation with pricing power and the ability to increase their profit margins.
3 Ways to Fight High Inflation Rates
As a consumer, there are plenty of strategies that you can start implementing to protect yourself and your family against inflation. Depending on what you expect in the future, your strategy may change.
For example, if you expect inflation to be lower shortly, you might save or invest your money for when it's worth more. On the other hand, if you expect inflation to increase, you might want to spend your money today since it has more purchasing power.
Let's take a look at three things you can do to fight the effects of high inflation.
Here you can learn how to protect yourself against inflation and keep your finances safe.
Buy Rather a Than Rent
When there is high inflation
, it usually favors owners rather than renters. When you rent your home, your landlord will most likely raise rent prices at the level of inflation when you renew your lease each year.
As a renter, your housing costs are vulnerable to changes during inflation. As a homeowner, your mortgage payments are typically fixed at a certain amount. Also, the value of your home will rise during inflation due to the cost of land, labor, and materials rising.
Improve Energy Efficiency
During periods of inflation, it's typical for gas prices to rise (as you may have noticed recently). Try reducing your gas bills by getting a more fuel-efficient vehicle. You can lower heating and cooling costs as well by energy-efficient projects like sealing the doors and windows in your home.
Pay Down Credit Card Debt
As prices everywhere continue to increase, it can be tempting to use your credit cards for more of your expenses. But if you take on more debt, the Federal Reserve will likely raise interest rates to fight against inflation.
This means your credit cards will become even harder to pay down in the future. Pay off your credit cards as quickly as possible to avoid this.
When Will Inflation Go Down?
There isn't a crystal clear answer to when prices will go down. This largely depends on the biggest contributors to inflation, including the resolving of global supply chain issues and when the Federal Reserve's increased interest rates finally slow the economy.
Some experts believe that inflation will drop just as quickly as it rose by sometime next year or the next few years.
Although we may have a tough time now, prices are estimated to go down
by 2023 according to research by Morningstar.
Protect Your Business and Finances
That's everything you need to know about the inflation causes.
Inflation can be a painful experience for both consumers and businesses, but know that there is a light at the end of the tunnel. By using smart financial decisions, your business can survive
and come out stronger than ever on the other side.
If you're looking to get a loan for your business with minimum requirements, apply now
and get a free quote today!
How is inflation measured?
There are a few ways that economists measure inflation, but the most important price tracker for normal consumers is the consumer price index used by the Labor Department. The inflation rate meaning is the increase or decrease in prices over a given time.
How much inflation is too much inflation?
There isn't a formally established inflation target, but it is generally believed that 2-3% inflation is healthy. The U.S. hasn't seen inflation that runs higher than 5% since the 1980s (until now).
Why are prices going up?
There are several reasons why prices are going up. These include:
These factors have collectively led to higher prices.
- Supply chain disruptions (lower supply)
- Increase in money supply (higher demand)
- Higher demand for services post-pandemic (higher demand)
- Material shortages due to the Ukraine-Russia conflict (lower supply)
Do prices go down after inflation?
Inflation prices are not seen to be permanent. Consumers can expect to start seeing falling prices in 2023.
What is the producer price index (PPI)?
The Producer Price Index (PPI) is a measure of the average price level for a basket of selected finished goods and services produced by domestic manufacturers.
The PPI covers nearly 400 items in 3 broad sectors: mining, manufacturing, and primaries (wood, textile, leather, etc.). It is one of the most closely watched indicators used by policymakers and economists to track inflationary pressure in the economy.