What to know about the main causes of inflation

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To ensure that your money is keeping pace with inflation, consider saving and investing your money when possible. You can also talk to your employer about cost of living adjustments over time. Portra/Getty Images; Insider
  • Inflation is the rising cost of goods and services over time.
  • A change in inflation is caused by a number of factors, such as increases in the cost of production or spikes in demand.
  • Inflation is measured on a monthly basis using the Consumer Price Index.
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From used cars to the housing market, the stock market, and beyond, inflation has always played a major role for consumers and investors alike. This is because as prices rise over time the buying power of your dollar slowly decays. But the rise and fall of inflation can occur for different reasons depending on the state of the economy.

So, what are the major 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 causes your buying power to erode, meaning that the same dollar today buys less in the future. “The simple story is too much money chasing too few goods and services,” says Dean Baker, senior economist at the Center for Economic and Policy Research.

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

Current inflation rate

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

To calculate inflation we begin 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 is meant to capture a portion of the items and services that urban households typically consume, but it is not meant to be all encompassing. Using that market basket, the consumer price index is created and the current value of the market basket is determined by adding each of the totals.

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

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-pull and cost-push inflation among the most common. However, the causes of inflation in 2021 are a bit more complex and have been caused in part because of the government’s response to the pandemic, in addition to sudden increases in demand as coronavirus lockdown restrictions faded and as labor shortages occurred across the country.

Here are the major causes of inflation:

1. Demand-pull inflation

Demand-pull inflation happens when the demand for certain goods and services is greater than the economy’s ability to meet those demands. When this demand outpaces supply, there’s an 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 far greater than capacity, the price of tickets skyrocketed approaching $US2,000 ($AU2,715) on third party sites, well above the standard ticket price of $US139 ($AU189) and premium ticket price of $US549 ($AU745) at the time.

2. Cost-push inflation

Cost-push inflation is the increase of prices when the cost of wages and materials goes up. These costs are often passed down to consumers in the form of higher prices for those goods and services. An example of this would be lumber, as lumber is an input good for houses. When the cost of lumber spiked as much as 400% earlier in 2021 it had an impact on the increase in housing prices resulting in inflation.

3. Increased money supply

Increased money supply is defined as the total amount of money in circulation, which includes cash, coins, and balances and bank accounts according to the Federal Reserve. If the money supply increases faster than the rate of production, this could result in inflation, particularly demand-pull inflation because there will be too many dollars chasing too few products. An increase in money supply is usually created by the Federal Reserve through a process called Open Market Operations (OMO).

4. Devaluation

Devaluation is downward adjustment in a country’s exchange rate, resulting in lower values for a country’s currency.

The devaluation of a currency makes a country’s exports less expensive, encouraging foreign nations to buy more of the devalued goods. Devaluation also makes foreign products for the devaluing country more expensive which encourages citizens of the devaluing country to buy domestic products over foreign imports.

China is perhaps most known for this tactic as the United States and other nations have frequently accused China of working to devalue the Yuan over the years.

5. Rising wages

Rising wages is exactly what it sounds like – an increase in what’s being paid to workers. “Wages are a cost of production,” adds Baker. “If wages rise a large amount, businesses will either have to pass the cost on, 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 increases in wages, like raising the minimum wage, compared to faster, more sudden wage growth seen in places like Silicon Valley. Some believe that an increase in wages could result in cost-push inflation due to the higher cost to businesses, while others believe that higher wages across the board (not just concentrated in certain sectors) will also increase demand enough to offset a spike in prices.

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

6. Policies and regulations

Certain policies can also result in either a cost-push or demand-pull inflation. When the government issues tax subsidies for certain products, it can increase demand. If that demand is higher than supply, costs could rise. Additionally, stringent building regulations and even rent stabilization policies could inadvertently increase costs and create an inflationary environment by passing those costs to residents or artificially reduce the supply of housing.

The financial takeaway

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

If you’re an entrepreneur, consider raising your rates incrementally. On the consumer side: “Remember that inflation is typically uneven,” adds Baker. “Some prices rise rapidly, while others can be stable or even falling.” This may 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 to beat inflation as well. “The interest rates they earn on their savings accounts will not likely cover the rising prices. The only caveat is if they have funds invested that are earning a higher rate of return than the inflation rate,” says Toney. Treasury Inflation-Protected Securities (also known as TIPS) are bonds issued by the US Treasury that adjust in value based on the CPI. Other hedges for inflation may include corporate bonds and dividend paying stocks and index funds.

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