Causes of Inflation
(The "Silent" Tax)

Often referred to as 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 occurs when imbalances between production and consumption are sustained for longer periods of time.

Inflation is considered a tax because it decreases your purchasing power. $1 today doesn't purchase as much as it did in the past. And $1 in the future won't purchase as much as it does today. The "silent" part is because you tend to ignore those facts in your daily life, with a few exceptions (have you seen gas prices lately?).

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. Built-In Inflation (i.e. Expectations)

In the end, the inflation you and I experience is a 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 capitalize on this trend by raising 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 during the winter, and the subsequent increasing the price of orange juice (also called a supply shock).

The lack of oranges lowers the total supply, making each orange more expensive. In order to stay in business, juice producers raise their prices in order to cover the increased cost of oranges.

Another good example is when you hear about airlines raising ticket prices because the price of jet fuel increased (also called "cost push"). You may have heard of "stagflation"; it is essentially a severe form of "cost push" inflation.

Expectations Cause Built-In Inflation

Built-in inflation is really just 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. Which means that the costs of living increase.

So you get more money each year, but the price of stuff goes up too.

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 much or too little 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 hyperinflation can occur.

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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