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What Causes Inflation?

Inflation is usually a hot topic. It’s something that the United States Federal Reserve monitors when trying to decide whether to hike the federal funds rate. Plus, it affects everything from business and investor decisions to the value of retirement savings. As you try to understand how inflation works and why it’s an issue, it might help to understand what causes inflation.

Check out our inflation calculator.

What Is Inflation?

Before we get into what causes inflation, let’s review the definition of inflation. There’s inflation whenever average prices have continuously been on the rise. As a result, your money loses its value and your savings and growing investments are no longer worth as much.

There are multiple types of inflation, including hyperinflation (inflation that happens at a fast pace) and stagflation (a period marked by increasing prices and high levels of unemployment). The opposite of inflation is deflation, which occurs when prices overall are on the decline.

In the U.S., the government uses something called the consumer price index (CPI) to determine where the inflation rate stands. In order to measure inflation, the consumer price index looks at certain groups of products and utilities that are commonly used by Americans in urban areas. The 200+ goods and services in the index are meant to represent consumer activity in the economy as a whole.

The GDP price deflator tracks inflation as well. It looks at the value of all goods and services produced within the country rather than a small basket of items, making it more thorough than the CPI.  Then there’s the Producer Price Index (PPI), which uses the prices that manufacturers pay to indicate the status of inflation.

The Main Causes of Inflation

What Causes Inflation?

When talking about the causes of inflation, two primary explanations tend to prevail. One theory says that there’s cost-push inflation. That’s an example of inflation triggered by actions on the supply side.

Central to that idea is the belief that prices go up when manufacturing and production costs go up. When companies are forced to spend more money to pay for raw materials or to account for rising import prices, wages or taxes, they produce less. A smaller supply coupled with an unchanging demand leads to inflation and consumers then have to deal with higher prices.

The costs associated with production can increase for a number of reasons. Raw materials can become more expensive if they become less readily available. Governments can raise taxes if they need additional sources of revenue and employees can ask for higher wages if they’re struggling to get by. Amid all of these changes, businesses can drive up their prices in order stay afloat and make profits.

Related Article: Up, Up and Away – Understanding Inflation

Economists don’t always agree on the factors that cause prices to shift upwards. Some say that the Federal Reserve’s choice to increase the amount of money circulating through the economy is a key cause of inflation. Another concept, known as demand-pull inflation, says that increasing demand pulls up prices.

Proponents of the theory of demand-pull inflation argue that there’s inflation when the aggregate demand (the total amount of goods and services desired in an economy) outpaces the aggregate supply. In other words, prices shoot up when there’s more competition for products in short supply.

A government’s decision to increase spending can contribute to demand-pull inflation. So can lower tax rates that boost consumer spending. Even the fear of inflation can lead to inflation if there’s a high demand and people start buying more, believing that prices will soon rise and goods will soon become unaffordable. Current events like wars and natural disasters can result in inflation if they reduce supply or cause consumers to increase their purchasing out of fear and uncertainty.

The Consequences of Inflation

The degree to which inflation affects the economy is based on whether we’re prepared for it. At its worst, inflation can seriously lower the value of the money you’ve invested and saved for retirement. Overall purchasing power declines and investors and consumers might drastically cut back on spending. Businesses might lay off many workers if they’re unsure of where the economy is headed.

Left unchecked, a high rate of inflation can spark a recession. That’s one reason the Federal Reserve might choose to bump up interest rates. When the Fed makes that call, it’s attempting to slow things down in the economy to combat or prevent inflation.

It’s important to keep in mind, however, that inflation isn’t necessarily negative. It can be the hallmark of a healthy and growing economy. What’s more, there are some positive effects of inflation. Increasing prices can encourage companies to produce more goods and inflation can be beneficial for borrowers who won’t owe their lenders as much money in real terms.

Related Article: How Should Inflation Affect My Investment Strategy?

Final Word

What Causes Inflation?

Inflation is associated with rising prices across the board. A variety of factors can cause inflation to occur, including imbalances between supply and demand and growing consumer confidence. While inflation is typically viewed rather negatively, it can actually be proof of an expanding economy.

Now that you know what drives inflation you may be worried about how inflation will affect your savings and investments. If so, you can refer to an inflation calculator and look for inflation-beating places to invest your money.

Photo credit: ©iStock.com/pat138241, ©iStock.com/Peter Zelei, ©iStock.com/AndreyPopov

Amanda Dixon Amanda Dixon is a personal finance writer and editor with an expertise in taxes and banking. She studied journalism and sociology at the University of Georgia. Her work has been featured in Business Insider, AOL, Bankrate, The Huffington Post, Fox Business News, Mashable and CBS News. Born and raised in metro Atlanta, Amanda currently lives in Brooklyn.
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