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causes of inflation

Inflation has many causes, but they mainly break down into two camps: demand-pull and cost-push. Demand-pull happens when an increase in the demand for goods and services leads producers to raise prices to maximize profits. Cost-push occurs when producers raise prices because their costs have gone up. Over time, inflation can significantly impact your cost of living. It affects everyone from ordinary people to businesses and the stock market. As an investor, you may want to seek the guidance of a financial advisor to help you hedge against inflation and protect your investments. But everyone can benefit from understanding the causes of inflation and what it truly means.

A Brief Explanation of Inflation

Inflation is an increase in the price level of goods and services throughout a specific time frame. Basically, it means that a dollar today buys less than it used to. It’s usually discussed in terms of a percentage rate. So if inflation is 2%, a carton of eggs that was $3 is now $3.06.

It may not sound like much, but remember that inflation reflects price increases across the economy. So with high inflation, people whose incomes don’t rise in tandem with the cost of living may no longer be able to afford their lifestyles.

If the inflation rate breaches 50%, you’ll find yourself in hyperinflation territory. You can expect prices on almost everything to skyrocket. When inflation occurs during a recession, you get stagflation. This can lead to hyper unemployment and extremely low purchasing power. So it’s no surprise that inflation is linked to what’s called the Misery Index, an economic bellwether that measures in part how the average person is faring against inflation.

Inflation plays an important role in the economy, affecting everyone’s finances. So you can understand it better, here’s an in-depth look at its five causes.

1. Growing Economy

In a growing or expanding economy, unemployment drops and wages usually rise. As a result, more people find themselves with more money in their pocket, which they’re willing to spend on luxuries as well as necessities. This higher demand allows suppliers to increase prices, which in turn leads to more jobs, which puts more money in circulation, and round and round it goes.

In this context, inflation is considered a positive thing. Indeed, the Federal Reserve wants there to be inflation, because it is a sign of a humming economy. But the Fed wants only a little inflation, and aims for a 2% annual core inflation rate. Many economists agree, putting the target annual inflation rate at 2% to 3% as measured by the consumer price index. They consider this a healthy increase as long as it doesn’t drastically outpace the growth of the economy as measured by gross domestic product (GDP).

Because a growing economy can lead to an increase in consumer spending and demand, it is considered a form of demand-pull inflation.

What Causes Inflation?

2. Expansion of the Money Supply

An expanded money supply can also drive demand-pull inflation. This happens when the Fed prints money at a rate higher than the growth rate of the economy. With more money in circulation, demand grows and prices go up.

Here’s another way to look at it: Think of an online auction. The more bidders (or the more money pursuing an object), the higher the price goes. Remember, money is essentially worth whatever we believe is valuable enough to trade it for.

3. Government Regulation

The government can impose new laws or tariffs that make it more expensive for companies to produce goods or import them. They pass on those higher expenses to consumers in the form of increased prices. This results in cost-push inflation.

4. Managing the National Debt

When the national debt skyrockets, the government has two main options. One is to raise taxes to make its debt payments. If it hikes corporate taxes, companies will likely shift the burden onto consumers through higher prices. This is another scenario of cost-push inflation.

The government’s other option, of course, is to print more money. As explained earlier, this can result in demand-pull inflation. So if the government uses both approaches to tackle the national debt, it may effect both demand-pull and cost-push inflation.

5. Exchange-Rate Changes

When the value of the U.S. dollar dips in relation to foreign currency, it has less purchasing power. In other words, imported products – the majority of consumer goods bought in America – become more expensive to buy. Their cost goes up. The resulting inflation is viewed as the cost-push kind.

The Consequences of Inflation

At its worst, inflation can seriously lower the value of the money you’ve invested and saved for retirement. It can also set off a vicious cycle that sparks a recession. With an overall decline of purchasing power, consumers drastically cut back on spending, even on necessities. As a result, businesses cut back on investing and spending, and they lay off workers. Unemployed workers, in turn, spend less than they used to, causing businesses to let even more people go.

However, before that happens, the Fed may choose to combat inflation by bumping up interest rates. This takes money out of circulation, thereby cooling the economy down before it overheats.

It’s important to keep in mind, though, that inflation isn’t necessarily negative. At the target rate of 2% to 3%, it can be the hallmark of a healthy and growing economy.

The Takeaway

causes of inflation

Inflation is associated with rising prices across the board. A variety of factors can cause inflation, including government action. Sometimes, even, it’s the government’s attempt to control inflation that can make it worse. But a little inflation is a good thing, proof of an expanding economy.

Tips on Protecting Your Retirement Savings from Inflation

  • Don’t leave inflation’s effect on your savings to hazy guesswork. This inflation calculator will give you a better sense of how much the money you have now will be worth when you retire. You should also consider inflation’s effect on your investment strategy.
  • To understand inflation-hedging investments like commodities, real estate and precious metals like gold and silver, you may want to turn to a financial advisor. Our SmartAsset financial advisor matching tool can help you find the top ones in your area. Just answer a few questions about your financial goals, and the tool connects you with up to three financial advisors in your area. You can then review their expertise and interview them before you decide to work with one.

Photo credit: ©iStock.com/YinYang, ©iStock.com/Peter Zelei, ©iStock.com/agrobacter

Javier Simon, CEPF® Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.
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