Inflation: definition, 6 economic causes

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  • Inflation is the increase in the cost of goods and services over time.
  • A change in inflation is caused by a number of factors, such as increases in production costs or spikes in demand.
  • Inflation is measured on a monthly basis using the Consumer Price Index.
  • Visit Insider’s Investment Reference Library for more stories.

From used cars to the housing market, the stock market and beyond, inflation has always played a major role for consumers and investors. This is because as prices increase over time, the purchasing power of your dollar slowly decreases. But rising and falling inflation can happen for different reasons depending on the state of the economy.

So what are the main causes of inflation and how is inflation measured?

What is inflation?

Inflation is the increase in the price of goods and services over time. Inflation erodes your purchasing power, which means that the same dollar today buys less in the future. “The simple story is, it’s too much money for too few goods and services,” says Dean Baker, senior economist at the Center for Economic and Policy Research.

The United States Bureau of Labor Statistics (BLS) measures the rate of inflation using the Consumer Price Index (CPI) and publish this data each month.

Current inflation rate

According to the Bureau of Labor Statistics (BLS), inflation rose 0.5% for July 2021. Because this is a lagging indicator, the most recent inflation statistic will always be from the previous month. Over the past 12 months ending in July 2021, inflation rose 5.4% before seasonal adjustment.

To calculate inflation, we start with a “market basket” of goods and services. The price level of this “market basket” is what is measured from month to month. This basket aims to capture some of the items and services that urban households typically consume, but it is not meant to be exhaustive. Using this market basket, the consumer price index is created and the present value of the market basket is determined by adding each of the totals.

The next step is to compare the cost of the current basket of items to the same basket of items during what is called a base period. Inflation is then calculated from the change in the price level of the base period commodity basket relative to the most recent period commodity basket. For example: if the CPI is 255 in July 2020 and 260 in July 2021, that would mean that inflation was 1.9% over that 12 month period.

The Bureau of Labor Statistics provides the CPI while the Bureau of Economic Analysis provides the PCE.

What causes inflation?

Inflation can be caused by multiple factors, with demand-side inflation and cost surges being some of the most common. However, the causes of inflation in 2021 are a bit more complex and were caused in part by the government’s response to the pandemic, in addition to sudden increases in demand as coronavirus lockdown restrictions fade and that labor shortages were occurring across the country.

Here are the main causes of inflation:

1. Demand-driven inflation

Demand-driven inflation occurs when the demand for certain goods and services is greater than the economy’s ability to meet those demands. When this demand exceeds supply, there is upward pressure on prices, causing inflation.

A practical example of this would be tickets to see Hamilton live on Broadway. Because there were a limited number of seats and the demand for the live show was well above capacity, ticket prices skyrocketed, approaching $ 2,000 at third-party sites, well above the standard ticket price of $ 139 and premium ticket price of $ 549 at the time. .

2. Cost-driven inflation

Cost push inflation is the increase in prices when the cost of wages and materials increases. These costs are often passed on to consumers in the form of higher prices for these goods and services. An example of this would be lumber, as lumber is a good input for homes. When the cost of wood soared to 400% earlier in 2021, it had an impact on rising house prices leading to inflation.

3. Increase in the money supply

The increase in money supply is defined as the total amount of money in circulation, which includes cash, coins, balances and bank accounts according to the

Federal Reserve
. If the money supply grows faster than the rate of production, it could lead to inflation, especially demand-driven inflation, because there will be too many dollars for too few products. An increase in the money supply is usually created by the Federal Reserve through a process called Open Market Operations (OMO).

4. Devaluation

Devaluation is a downward adjustment in a country’s exchange rate, causing the values ​​of a country’s currency to fall.

Devaluation of a currency makes a country’s exports cheaper, encouraging foreign countries to buy more devalued goods. Devaluation also makes foreign goods for the devaluing country more expensive, which encourages citizens of the devaluing country to buy domestic goods rather than foreign imports.

China is perhaps best known for this tactic, as the United States and other countries have frequently accused China of working to devalue the yuan over the years.

5. Wage increase

The increase in wages is exactly what it sounds like – an increase in what workers are paid. “Wages are a cost of production,” adds Baker. “If wages increase significantly, companies will either have to pass on the costs or live with lower margins. The exception is if they can offset wage growth with higher productivity.”

However, economists remain mixed on the impact of gradual wage increases, like increasing the minimum wage, compared to the faster and more sudden wage growth seen in places like Silicon Valley. Some believe that an increase in wages could lead to cost inflation due to the higher cost to businesses, while others believe that higher wages in all areas (not just concentrated in certain sectors) will also increase. enough demand to offset a surge in prices.

“Rising wages should enable consumers to fight inflation, especially if wages are rising at the same rate or faster than the rate of inflation,” adds Susane L. Toney, Ph.D, chair of Business and Economics from Hampton University. “Rising wages allow consumers to pay higher prices without impacting their purchasing power.”

6. Policies and regulations

Some policies can also lead to cost or demand inflation. When the government grants tax subsidies for certain products, it can increase demand. If this demand is greater than the supply, the costs could increase. Moreover, strict building regulations and even rent stabilization policies could inadvertently increase costs and create an inflationary environment by passing these costs on to residents or artificially reducing the supply of housing.

The financial report

Inflation, typically around 2% per year, is a normal part of our economic system. Under normal financial circumstances, this means your money is worth less each year, unless it earns an interest rate greater than or equal to inflation. To make sure your money keeps pace with inflation, consider annual salary increases or cost-of-living adjustments by your employer.

If you are an entrepreneur, consider increasing your rates gradually. On the consumer side: “Remember that inflation is generally uneven,” adds Baker. “Some prices go up quickly, while others can be stable or even go down.” This can be an opportunity to save money by waiting for better prices or finding a substitute item or service.

Investing your money is also an effective tactic for beating inflation. “The interest rates they earn on their savings accounts are unlikely to cover the price increase. The only caveat is if they have invested funds that pay a higher rate of return than the rate of return. ‘inflation,’ says Toney. Inflation-Protected Treasury Securities (also known as TIPS) are bonds issued by the US Treasury whose value adjusts according to the CPI. Other inflation hedges can include corporate bonds, dividend-paying stocks, and index funds.


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