Causes of Inflation
(The "Silent" Tax)

All the causes of inflation begin with supply and demand.

Goods and services are produced (supply) and then purchased (demand), and money moves through the economy.

Naturally, supply and demand fluctuate over time; you don't need a new TV every month.

Inflation is caused by when imbalances between production and consumption are sustained for longer periods of time.

Let's start with the three types of inflation, and then dive into the causes of each one.

The most common terms for the types of inflation are:

  1. Price Inflation (i.e. Pull, Demand or Excess Demand)
  2. Cost Inflation (i.e. Push, or Supply "Shock")
  3. Pricing Power (Built In Inflation)

In the end, inflation is caused by some combination of all three types.

Excess Demand Causes Price Inflation

When demand is greater than supply, people are trying to buy more stuff than is currently being made. The principle of scarcity kicks in, people are willing to pay more for something that is scarce, and price inflation is created.

Ever see an auction? People talk about bidding up the price (also called "demand-pull")...this is classic price inflation; people keep making higher and higher bids in an attempt to purchase something.

On a large scale, we see this happen when the economy is humming along; people get hired, make more money, buy more things. Companies try to capture this trend by increasing prices.

Supply "Shock" Causes Cost Inflation

Cost inflation occurs when the cost of producing a good or service increases, and that increase is passed on to the consumer in the form of higher prices.

A common example of this type of inflation is the loss of an orange crop increasing the price of orange juice (also called a supply shock). The loss in supply means that orange juice producers must charge more to stay in business, because it costs them more to buy oranges. Therefore, the lack of oranges creates an increase in price.

Another good example is when you hear about airlines raising ticket prices because the price of jet fuel has increased (also called "cost push").

Expecting Inflation Causes Pricing Power

Pricing power is really a combination of price and cost inflation. This type occurs because we expect inflation in the future purely because it happened in the past.

Employees expect their cost of living to increase each year, so they push for raises (hence the term cost of living raise). To offset the increased wages, companies pass along the increased "cost" of their labor by increasing the price of their products and services. So the price of stuff increases.

Why are the Causes of Inflation a Big Deal?

The causes of inflation are important because of inflation's bipolar nature.

Some amount of inflation is good and means the economy is growing. However, too little or too much is bad for the economy, and controlling the amount is tricky.

If inflation is too low, then deflation can occur.

If inflation is too high, then prices also tend to be high and "hyperinflation" can occur.

So inflation that is too high is bad, and not enough is bad. This is why you hear politicians and federal reserve employees talk about a sweet spot for inflation. Usually, the Fed tries to take actions that balance growth and inflation at a "moderate" rate.

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