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Updated at 2018/07/12

Inflation affects everything around us, from basic necessities like housing, food, medical care and utilities to the cost of cosmetics and new automobiles. Furthermore, inflation can effortlessly deteriorate our savings. It makes the money saved today less valuable tomorrow, eroding our future purchasing power and even interfering with our ability to retire. 

Central banks monitor inflation closely, as it is the overriding force behind monetary policies. These are the monetary policies that impact the level of money supply and the availability of credit within an economy. Central banks of developed economies, including the Federal Reserve in the United States, generally aim to keep the inflation rate around 2%. In this article, we will examine the fundamental factors behind inflation, different types of inflation and who benefits from it.

Causes of Inflation

Consumer Confidence: When unemployment is low and wages are stable, consumers are more confident and more likely to spend money. This confidence drives up prices as manufacturers and providers charge more for goods and services that are in high demand. One example is the market for new housing. In a booming economy, people purchase more new houses. Contractors experience greater demand for their services, and they raise their prices to capitalize on that demand. Similarly, the building materials included in the houses also cost more as supplies dwindle and consumers increase what they are willing to pay to complete the project. (For related reading, see: How Inflation and Unemployment Are Related.)

Decreases in Supply: One of the basic causes of inflation is the economic principle of supply and demand. As 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. Supply decreases for several reasons. Oftentimes a natural disaster or environmental effect is at fault for a supply-chain interruption, such as when a tornado destroys a factory or a severe drought kills crops. Supplies also decrease when an item is immensely popular, a phenomenon that frequently is seen when new cellphones or video games are released.

Corporate Decisions: Sometimes inflation happens naturally as supplies decrease and demand increases, but other times it is orchestrated by corporations. Companies that make popular items frequently 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.

Decisions made by business owners can cause inflation even when it wasn't the intended effect. Farmers often decide to thin their cattle herds when the price of feed increases. That decision saves the farmers money, but it means that less beef is available for sale, driving up the price and sparking inflation. (For related reading, see: Inflation's Impact on Stock Returns.)

How Inflation Rates Are Determined

The inflation rate is determined by the rate of change in a price index. The most cited and analyzed price index in the United States is the Consumer Price Index for All Urban Consumers (CPI-U), which is released by the Bureau of Labor Statistics each month . The Consumer Price Index for All Urban Consumers is a weighted basket of goods and services, ranging from food and beverage to education and recreation. A second, often-quoted price index is the producer price index (PPI), which includes things like fuels and farm products (meats and grains), chemical products and metals. The producer price index reports the price changes that affect domestic producers, and you can often see these prices changes being passed on to the consumers some time later in the Consumer Price Index. 

Types of Inflation

Cost-Push Inflation

Cost-push inflation is one of two main types of inflation within an economy. It refers to rising costs of production (usually in the form of wages) contributing to increasing pricing pressure. One of the signs of possible cost-push inflation can be seen in rising commodity prices, as commodities like oil and metals are major production inputs. 

Wages also affect the cost of production as the single biggest expense for businesses. Analysts and policy makers currently see the labor market, through the unemployment rate, as the most important production input. As shortages in labor can create pressure to raise wages, it flows naturally that the lower the unemployment rate, the higher the possibility of labor shortages. 

Demand-Pull Inflation

While cost-push inflation is a supply-side issue, demand-pull inflation occurs when high demand causes rising prices. Demand-pull inflation can be caused by factors such as the following:

  • Expansionary fiscal policy. By lowering taxes, governments can increase the amount of discretionary income for both business and consumers. Businesses may spend it on capital improvements, employee compensation or new hiring, among other things. Consumers may purchase more nonessential items. Furthermore, as the government stimulates the economy by increasing its spending, say by undertaking major infrastructure projects, the demand for goods and services will increase, leading to price increases.
  • Devaluation of the currency. Currency devaluation can lead to higher exports (as our goods become suddenly less expensive and thus more attractive to foreign buyers) and this increases aggregate demand for our goods and services. Higher demand can lead to high prices. Currency devaluation can also result in lower imports (as foreign goods become suddenly more expensive to purchase with devalued dollars). 
  • Expansionary monetary policy. Through open market operations, central banks can increase the money supply and create a surplus of liquidity that can bring down the value of money vis-à-vis the price of goods. In other words, by expanding the money supply, the purchasing power of all the participants in an economy increases, leading to a rise in aggregate demand. If the supply of goods do not adjust with this excess demand, then there will upwards pressure on prices. (See also: Cost-Push Inflation Versus Demand-Pull Inflation.)

Inflationary Expectations

Once inflation becomes prevalent enough in an economy, the expectation of further inflation becomes an overriding concern in the consciousness of consumers and businesses alike. These expectations then become a guiding principle behind the actions of these economic agents, causing inflation to persist in an economy long after the initial shock has dissipated.

The Benefits of Inflation

While consumers experience little benefit from inflation, some individuals reap the rewards. Manufacturers can charge more for their products and contractors can raise their prices. Business owners can deliberately withhold supplies from the market, allowing prices to rise to a favorable level. Investors also enjoy a boost if they hold assets in the markets affected by inflation. (For related reading, see: How to Benefit from Inflation.)

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