Have you ever wondered why things were always cheaper in the past? For instance, a wallet that cost $5 when your parents were kids could be priced at $15 in today’s currency.
As time passes, the same amount of money becomes insufficient to purchase the same items as it could a few years ago. This phenomenon can be ascribed to the concept known as inflation.
Inflation is the rate of increase in the price of goods and services over some time. While most people understand what inflation is, they do not always understand why inflation exists. Therefore, in this article, we discuss everything you need to know about what causes inflation.
What Causes Inflation?
Traditional economics would dictate that there are three primary causes for inflation: demand-pull inflation, cost-push inflation, and increased money supply.
Inflation is a vital economic concept but it can be difficult to grasp. Let’s talk about how inflation affects a business and possible solutions.
These factors are not too complicated and can be easily explained using some simple economic rules.
What Is Cost-Push Inflation?
Cost-push inflation is a type of inflation that occurs when the cost of production increases, leading to a higher overall price level in the economy.
When companies face a greater cost to produce the same products, they tend to pass the excess cost on to the consumers by raising prices. Therefore, as the cost of production increases, so do the prices of goods and services.
There are several factors that can contribute to cost-push inflation, including:
Increased Input Costs
If the cost of raw materials or other inputs used in the production process increases, it can lead to higher costs for businesses.
Increased Wage Costs
If the cost of labor increases, it can also contribute to higher costs for businesses. This could be due to factors such as an increase in the minimum wage or negotiations for higher wages by workers.
Increased Taxes or Regulations
If the government imposes new taxes or regulations on businesses, it can increase their costs and lead to higher prices for consumers. This practice is known as passing the tax down to consumers.
In all 3 of the reasons above, the production cost increases. As a result of these higher costs, businesses may need to raise the prices they charge for their products in order to maintain their profit margins. If the cost increases are widespread across the economy, they can lead to a general increase in prices, which is known as inflation.
For example, consider a hypothetical economy that produces a single good called “widgets.” If the cost of the raw materials used to produce widgets increases, the widget factory may need to raise the price it charges for widgets in order to cover its higher production costs.
If other businesses in the economy are also facing higher costs, they may need to raise their prices as well. Consequently, the overall price level in the economy will increase, leading to inflation.
Note: inflation will always exist in the long term; therefore, you should always try to save money and account for inflation in your personal financial plan.
What Is Demand-Pull Inflation?
Demand-pull inflation is a type of inflation that occurs when the overall demand for goods and services in an economy exceeds the available supply. When this happens, businesses may need to raise their prices in order to balance supply and demand, leading to an overall increase in the price level in the economy, which is known as inflation.
Demand-pull is a better reflection of what happens when the economy is very close to full capacity. In a well functioning economy, people may feel that they have more disposable income to spend, and therefore demand for goods and services may go up.
If companies are already operating at full capacity, they won’t be able to increase their production to keep up with that increasing demand.
There are several factors that can contribute to demand-pull inflation, including:
Economic Growth
When an economy is growing and unemployment is low, people tend to have more disposable income, which they can use to buy goods and services. As a result, the market sees more buyers, inducing businesses to raise prices.
Increased Government Spending
If the government increases its spending on goods and services, it can lead to higher demand and, in turn, higher prices.
Credit Expansion
If banks make it easier for people to borrow money, it can lead to increased spending and higher demand for goods and services, which can contribute to inflation.
Higher Exports
If a country’s exports increase, it can lead to higher demand for domestic goods and services, resulting in inflation.
Overall, demand-pull inflation is caused by an increase in demand for goods and services that exceeds the available supply, leading to higher prices.
How Does Increased Money Supply Cause Inflation?
An increase in the money supply can lead to inflation if it results in more money being available to buy the same amount of goods and services.
This can happen if the central bank, which is responsible for managing the money supply, increases the amount of money in circulation without a corresponding increase in the supply of goods and services.
Here’s how it works: Imagine that the central bank increases the money supply by printing more money and distributing it to the public. At first, people will have more money to spend, which can lead to an increase in demand for goods and services.
However, if the supply of goods and services remains stagnant, this increase in demand will lead to higher prices. In other words, more money chasing the same amount of goods and services will bid up the prices of those goods and services.
Inflation can also occur if the increased money supply leads to increased borrowing and spending.
For example, if the central bank lowers interest rates, it can encourage people and businesses to borrow more money. This can lead to an increase in demand for goods and services, which, in turn, can increase prices.
Overall, an increase in the money supply can lead to inflation if it results in more money being available to buy the same amount of goods and services, or if it leads to increased borrowing and spending.
Conclusion
Inflation is a common occurrence, especially in the current world, where almost every country is experiencing high inflation levels.
In order to deal with rising prices, you must learn how to save money. For instance, Investmentpedia.org has written an article on how you can save taxes.
If you learn the causes of inflation and what you can do to limit the effect inflation has on you, you will set yourself up for financial success in the long term.
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