What causes inflation?

Prices don’t just grow by themselves, so what are the fundamental factors that steadily erode the dollar’s purchasing power or any other currency? There are two major inflation causes: Demand-pull, and Cost-push. Both are responsible for an overall rise in economic prices. But they do work in a particular way. Conditions for demand-pull occur as market demand pulses prices up. Cost-push happens when the prices of the market force are higher.

Inflation by demand-pull is the most frequent cause of rising prices. It happens when the demand for goods and services grows so fast that supply is outstripped. Manufacturers can not make enough to satisfy demand. They do not have the resources to build the fabrication they need to improve supply. Maybe they do not have enough professional employees to do it. Or maybe raw materials are scarce.

If sellers do not increase the price they are going to sell out. They soon know that they now have the opportunity to drive prices up. If this is done enough, they are causing inflation.

There are several circumstances which create inflation from demand-pull. For example, a rising economy influences inflation because they spend more as people are having better jobs and are more optimistic.

When prices go up, people tend to expect inflation. The anticipation is driving customers to spend more now to prevent potential price rises. This further stimulates development. A little bit of inflation is nice for that reason. That is recognized by most central banks. They set a target for inflation in order to control inflation expectations from the public. The U.S. central bank, the Federal Reserve, has set a core inflation rate target of 2 per cent. The core rate does away with the impact of seasonal food and increased energy costs.

Another circumstance is discretionary fiscal policy. That’s when the government either spends more or taxes less.3 Putting extra money in people’s pockets increases demand and spurs inflation.

Marketing and emerging technologies for particular goods or asset groups generate demand-pull inflation. The resulting asset inflation will cause widespread price hikes. Inflation of assets and salaries is kind of inflation. Apple is using branding for example to generate demand for its goods. This helps it to pay rates higher than the competition. And there was new technology in the form of financial derivatives. In 2005 these new technologies produced a period of boom and bust in the housing market.

Over-expansion of the money supply can also create demand-pull inflation. The money supply is not just cash, but also credit, loans, and mortgages. When the money supply expands, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. That increases prices in the general economy.

How exactly does the money supply increase? Through expansionary fiscal policy or expansionary monetary policy. The federal government executes expansionary fiscal policy. It expands the money supply through either deficit spending. Deficit spending pumps money into certain segments of the economy. It creates demand-pull inflation in that area. It delays the offsetting taxes and adds it to the debt. It has no ill effect until the ratio of debt to gross domestic product approaches 90%.

The government will sometimes generate inflation by simply printing out more currency. Venezuela did this from 2013 to 2019. It produced hyperinflation, and the money went worthless too.

Another mechanism is to lower the amount of fed funds. That is the rate banks charge each other for borrowing funds to retain the requirement for the Reserve. This intervention reduces all interest rates, as well. This enables borrowers to take out a bigger loan at the same rate. It has the same impact of reducing the fed funds rate. But it is also simpler. It is achieved a lot more frequently as a result. Too much money chases too few commodities and causes inflation as loans become cheap. The prices of everything increase, even though neither demand nor supply has changed.

The second reason for the cause of inflation is the cost-push theory, which notes that the cost of raw materials rises and labor pushes prices of goods and services upward. Bread serves as a good example. When the price of wheat rises, the price of meal increases, which causes the cost of bread to rise (pun intended).

But are the price rises of individual goods really causing inflation? Lots of economists are saying no. Demand for bread, for example, is rising but the baker is not immediately raising his prices. Instead it first depletes its flour supply. If there continues to be increased demand, he will buy more meal from his supplier, who will buy more wheat from his farmer. Imagine making equal demands on his fellow bakers. Because all vendors want more grain, they are going to pay more money to the farmer for his wheat, which will cause the price to go up on wheat, grain, and ultimately bread. So even though it seems like the higher cost of raw materials is responsible for the higher cost of the final item, it was actually the aggregate demand for the final product that caused the price to go up.

Although consumers gain little benefit from inflation, investors may take advantage of a boost if they hold assets in inflation-affected markets. For example, if energy prices rise, those who are invested in energy companies may see an increase in their stock prices.

Some businesses are reaping inflation benefits if they can charge more for their products as a result of a increase in demand for their goods. If the economy performs well, and the demand for housing is strong, home-building firms will charge higher prices for home sales.

In other words, inflation can provide businesses with pricing power and increase their profit margins. If profit margins are rising, it means the prices that companies charge for their products are increasing at a faster rate than increases in production costs.

Corporate owners may also purposely withhold products from the market, causing prices to increase to a desirable level. Yet businesses will also be affected by inflation if it is the result of an rise in cost of output. Companies are at risk because they can not pass on the increased costs by increased prices to customers. For example, if international competition is unaffected by the rises in production costs, their prices do not rise. As a result , U.S. businesses would have to bear the higher cost of manufacturing, or they risk losing consumers to foreign companies.

So is inflation a good thing? The short answer as you can see from above is it really depends. 

Check out my related post: What is C-R-A-P?

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