What Causes Inflation?

Inflation is a measure of the rate of rising prices of goods and services in an economy. If inflation is occurring, leading to higher prices for basic necessities such as food, it can have a negative impact on society.

Inflation can occur in nearly any product or service, including need-based expenses such as housing, food, medical care, and utilities, as well as want expenses, such as cosmetics, automobiles, and jewelry. Once inflation becomes prevalent throughout an economy, the expectation of further inflation becomes an overriding concern in the consciousness of consumers and businesses alike.

Central banks of developed economies, including the Federal Reserve in the U.S., monitor inflation. The Fed has an inflation target of approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.

Inflation can be a concern because it makes money saved today less valuable tomorrow. Inflation erodes a consumer’s purchasing power and can even interfere with the ability to retire. For example, if an investor earned 5% from investments in stocks and bonds, but the inflation rate was 3%, the investor only earned 2% in real terms. In this article, we’ll examine the fundamental factors behind inflation, different types of inflation, and who benefits from it.

What Drives Inflation

There are various factors that can drive prices or inflation in an economy. Typically, inflation results from an increase in production costs or an increase in demand for products and services.

Cost-Push Inflation

Cost-push inflation occurs when prices increase due to increases in production costs, such as raw materials and wages. The demand for goods is unchanged while the supply of goods declines due to the higher costs of production. As a result, the added costs of production are passed onto consumers in the form of higher prices for the finished goods.

One of the signs of possible cost-push inflation can be seen in rising commodity prices such as oil and metals since they’re major production inputs. For example, if the price of copper rises, companies that use copper to make their products might increase the prices of their goods. If the demand for the product is independent of the demand for copper, the business will pass on the higher costs of raw materials to consumers. The result is higher prices for consumers without any change in demand for the products consumed.

Wages also affect the cost of production and are typically the single biggest expense for businesses. When the economy is performing well, and the unemployment rate is low, shortages in labor or workers can occur. Companies, in turn, increase wages to attract qualified candidates, causing production costs to rise for the company. If the company raises prices due to the rise in employee wages, cost-plus inflation occurs.

Natural disasters can also drive prices higher. For example, if a hurricane destroys a crop such as corn, prices can rise across the economy since corn is used in many products.

Demand-Pull Inflation

Demand-pull inflation can be caused by strong consumer demand for a product or service. When there’s a surge in demand for a wide breadth of goods across an economy, their prices tend to increase. While this is not often a concern for short-term imbalances of supply and demand, sustained demand can reverberate in the economy and raise costs for other goods; the result is demand-pull inflation.

Consumer confidence tends to be high when unemployment is low, and wages are rising—leading to more spending. Economic expansion has a direct impact on the level of consumer spending in an economy, which can lead to a high demand for products and services.

As the demand for a particular good or service increases, the available supply decreases. When fewer items are available, consumers are willing to pay more to obtain the item—as outlined in the economic principle of supply and demand. The result is higher prices due to demand-pull inflation.

Companies also play a role in inflation, especially if they manufacture popular products. A company can raise prices simply because consumers are willing to pay the increased amount. Corporations also raise prices freely when the item for sale is something consumers need for everyday existence, such as oil and gas. However, it’s the demand from consumers that provides the corporations with the leverage to raise prices.

The Housing Market

The housing market, for example, has seen its ups and downs over the years. If homes are in demand because the economy is experiencing an expansion, home prices will rise. The demand also impacts ancillary products and services that support the housing industry. Construction products such as lumber and steel, as well as the nails and rivets used in homes, might all see increases in demand resulting from higher demand for homes.

Expansionary Fiscal Policy

Expansionary fiscal policy by governments can increase the amount of discretionary income for both businesses and consumers. If a government cuts taxes, businesses may spend it on capital improvements, employee compensation, or new hiring. Consumers may purchase more goods as well. The government could also stimulate the economy by increasing spending on infrastructure projects. The result could be an increase in demand for goods and services, leading to price increases.

Expansionary monetary policy by central banks can lower interest rates. Central banks like the Federal Reserve can lower the cost for banks to lend, which allows banks to lend more money to businesses and consumers. The increase in money available throughout the economy leads to more spending and demand for goods and services.

Measures of Inflation

There are a few metrics that are used to measure the inflation rate. One of the most popular is the Consumer Price Index (CPI), which measures prices for a basket of goods and services in the economy, including food, cars, education, and recreation.

Another measure of inflation is the Producer Price Index (PPI), which reports the price changes that affect domestic producers. The PPI measures prices for fuel, farm products (meats and grains), chemical products, and metals. If the price increases that cause the PPI to spike get passed onto consumers, it will be reflected in the Consumer Price Index.

Who Benefits From Inflation?

While consumers experience little benefit from inflation, investors can enjoy a boost if they hold assets in markets affected by inflation. For example, those who are invested in energy companies might see a rise in their stock prices if energy prices are rising.

Some companies reap the rewards of inflation if they can charge more for their products as a result of a surge in demand for their goods. If the economy is performing well and housing demand is high, home-building companies can charge higher prices for selling homes.

In other words, inflation can provide businesses with pricing power and increase their profit margins. If profit margins are rising, it means the prices that companies charge for their products are increasing at a faster rate than increases in production costs.

Also, business owners can deliberately withhold supplies from the market, allowing prices to rise to a favorable level. However, companies can also be hurt by inflation if it’s the result of a surge in production costs. Companies are at risk if they’re unable to pass on the higher costs to consumers through higher prices. If foreign competition, for example, is unaffected by the production cost increases, their prices wouldn’t need to rise. As a result, U.S. companies might have to eat the higher production costs, otherwise, risk losing customers to foreign-based companies.