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3 Types of Inflation and How to Prepare


As prices climb and the cost of living increases, the question on many minds is how to safeguard their financial future against inflation. Understanding different types of inflation — demand-pull, cost-push and built-in — and how they impact purchasing power will help you strategize effectively. From investment diversification to energy-efficient practices and fixed-rate loans, the strategies outlined here can help you maintain your purchasing power and financial stability in an ever-changing economic environment. If you need help with your own finances and want to build wealth then you may want to talk to a financial advisor.

How Inflation Works

Inflation affects virtually every individual and market. At its core, it refers to the rate at which the general level of prices for goods and services rises, leading to a corresponding decrease in the purchasing power of a currency. Central banks, such as the Federal Reserve in the United States, strive to control inflation — and prevent deflation — to ensure the economy operates smoothly. By influencing interest rates and employing other monetary policy tools, which are essential strategies to manage the nation’s money supply and influence the economy’s overall health, central banks aim to maintain inflation at a manageable level, typically setting an inflation target that is considered healthy for economic growth.

The implications of inflation are far-reaching, affecting both individuals and markets. For individuals, inflation erodes purchasing power. A dollar today, for example, will not buy the same amount of goods or services in the future if inflation persists. On a broader scale, inflation influences consumer behavior, often leading to earlier spending or investment to preempt future price increases. This shift can alter investment strategies, with a preference for assets that have historically outpaced inflation, such as equities or real estate. Governments and central banks could adjust monetary policy in response to inflationary trends, using tools like interest rate adjustments to regulate economic expansion and preserve currency stability.

Here are three types of inflation:

1. Demand-Pull Inflation

Demand-pull inflation occurs when the overall demand for goods and services in an economy outpaces the available supply, leading to an increase in prices. A real-world example of this could be seen during economic booms when consumer confidence is high, and spending increases.

For example, the rapid economic expansion of the 1960s in the United States led to a surge in demand that outstripped supply, causing prices to rise. To manage or mitigate demand-pull inflation, economic policy may involve tightening monetary policy, such as raising interest rates to cool off consumer spending. By making borrowing more expensive, the central bank can temper the excessive demand that contributes to inflation.

Consequently, this type of inflation can can lead to higher prices for goods and services, thereby reducing your purchasing power. This could in turn eat into your savings, as your wages may not keep pace with rising costs.

2. Cost-Push Inflation

Cost-push inflation occurs when the costs of production, such as raw materials and wages, increase, leading to higher prices for consumers. This inflationary pressure can be triggered by various factors, such as supply chain disruptions or surges in the prices of essential commodities. A historical example is the oil price shock of the 1970s, which dramatically escalated the cost of production for many goods and services, resulting in widespread inflation.

More recently, events like the COVID-19 pandemic have caused similar disruptions, leading to increased costs for businesses and subsequent price rises for consumers. To respond to cost-push inflation, individuals and businesses can explore ways to reduce reliance on affected commodities or improve operational efficiencies. For example, a business might invest in alternative energy sources to mitigate the impact of rising oil prices.

Cost-push inflation could increase prices for goods and services for essentials like energy and housing, as well as goods and services that require significant inputs of labor or raw materials.

3. Built-In Inflation

Built-in inflation, also known as wage-price inflation, is a self-sustaining form of inflation that occurs when workers demand higher wages to keep pace with the rising cost of living, leading to higher prices for goods and services as businesses pass on these costs. This dynamic can create a feedback loop, where wage increases lead to price increases, which in turn lead to further wage demands.

Policymakers or businesses might address built-in inflation by implementing policies that moderate wage growth in line with productivity gains or by investing in technologies that improve efficiency.

Like with the other two types of inflation, wage-price inflation could impact you directly by potentially eroding your purchasing power if wages fail to keep pace with rising prices. And this can lead to reduced real income and a decrease in your standard of living.

Tips to Help Prepare Your Finances for Inflation

A couple reviewing how inflation has affected their investments.

In anticipation of inflation, individuals and businesses can employ various strategies to safeguard their financial positions. For example, in response to demand-pull inflation, one might consider investing in assets that are likely to appreciate or at least maintain their value over time, such as real estate or dividend-paying stocks.

When preparing for cost-push inflation, diversifying one’s investment portfolio to include commodities such as gold or oil can serve as a hedge against rising production costs. Moreover, businesses can enhance their operational efficiency to mitigate the impact of increased costs.

And for built-in inflation, individuals may seek employment in sectors that are less affected by inflationary pressures or enhance their qualifications and skills to command higher wages. On the business front, investing in technology to automate processes can reduce labor costs and help manage expenses more effectively.

Bottom Line

A couple meeting with an advisor to discuss how to protect their retirement nest egg from inflation.

Inflation can affect you in different ways. Demand-pull, cost-push and built-in inflation have distinct causes and implications. And understanding the differences could allow you adopt specific strategies to retain your purchasing power and financial stability.

Tips for Financial Planning

  • A financial advisor can help you create a plan to protect your finances from different types of inflation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Interested in plotting the value of a dollar over time to help you plan for the future? Consider using an inflation calculator.

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