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- Inflation is an increase in the prices of goods and services over time due to an imbalance between demand and supply.
- Increased costs including wages, government policies, and devaluation of the dollar all play a role in inflation.
- The government attempts to control inflation by encouraging or discouraging spending and investing.
According to the US Bureau of Labor Statistics, $20 worth of groceries bought in 1967 would cost about $181 in 2023. That’s 805% more for the same bag of groceries. The question is: Why the price increase?
The answer is “inflation.” And it can have multiple causes.
What does inflation mean?
Inflation is an increase in the price of goods and services over time. Cristian deRitis, deputy chief economist at Moody’s Analytics puts it this way: “Fundamentally, inflation comes down to an imbalance between supply and demand for goods and services in the economy.”
In other words, the primary cause of inflation is when demand outpaces supply or supply lags behind demand. The value of the product or service rises when demand and supply are not in a state of equilibrium. If many people want a product or service, and the supply remains constant or decreases, the seller can increase the price. If few people want the product or service, its value decreases, along with the price the seller can charge.
Inflation also devalues the dollars used to purchase the product or service. If you have to pay $2 for something that used to cost $1, the dollar is obviously worth less.
Inflation doesn’t exist in a vacuum. It applies across sectors or industries and affects the entire economy. The federal government attempts to control inflation by encouraging (or discouraging) spending and investing to maintain what it considers a healthy inflation rate of 2%. The Federal Reserve does its part by raising or lowering base interest rates.
What causes inflation?
Inflation is typically caused by demand outpacing supply, but the historical reasons for this phenomenon can be further broken down into demand-pull inflation, cost-push inflation, increased money supply, devaluation, rising wages, and monetary and fiscal policies.
“At this point, inflation is mainly being driven by demand,” says Callie Cox, US investment analyst at eToro. “Supply chains have healed and goods prices have cooled, but the Fed is laser-focused on services – rent, medical bills, insurance costs, etc.”
The most common cause for a rise in prices is when more buyers want a product or service than the seller has available. It’s interesting because, unless there’s a reason the supply is diminished that affects cost, the price doesn’t have to increase. It rises because sellers recognize that buyers are willing to pay more if it’s something they really want.
An example of this type of demand-pull inflation would be tickets to the Super Bowl. There are only so many seats available (limited supply). More people want to attend the Super Bowl than the number of available seats (increased demand). Because of this, third-party sellers can charge thousands of dollars for tickets with a face value equal to a fraction of that amount.
Sometimes prices rise because costs go up on the supply side of the equation. These increased supply-side cost such as materials, wages, and energy, make the product or service more expensive. Therefore the seller has to charge more to maintain a profit. Depending on the amount of demand, sellers may not always be able to recover all of the increase, but instead reduce their profit and absorb some of the cost themselves.
Cost-push inflation is often affected by changes in the labor market.
“Limitations on the availability of workers have led to wage increases and higher prices,” says deRitis. “Deaths and illnesses related to the pandemic reduced the size of the workforce both directly and indirectly.”
3. Increased money supply
Ideally, an increase in the supply of money in the economy lowers interest rates which encourages spending and investment and helps grow gross domestic product (GDP). However, this process, known as quantitative easing (QE), initiated by the Federal Reserve, can also lead to demand-pull inflation when the money supply increases faster than economic growth.
This happened during the COVID-19 pandemic. Governments worldwide, including the US, began massive financial support programs including $1 trillion in cash to Americans. This influx of money in the economy increased demand for goods and services and, for a variety of reasons, businesses could not keep up. The result: inflation and the eventual need for the Federal Reserve to begin cutting back on QE to slow down inflation.
Devaluation is a reduction in the value of currency when the exchange rate for that currency goes lower. This makes exports less expensive and more attractive to other countries. This process also makes products from other countries more expensive in the U.S.
Cost-push inflation results because imports are now more expensive which creates an imbalance on the supply (cost) side. Demand-pull inflation, caused by increased demand for domestic products both at home and abroad, can result in more demand than supply. Prices can rise and inflation result either way.
5. Rising wages
Rising wages are a contributor to cost-push inflation. That’s because wages are a cost. When workers are paid more, whatever they produce costs more and those costs are passed on to the consumer (buyer).
As with devaluation, there’s also a demand-pull inflationary aspect to rising wages. Higher wages put more money in the hands of consumers who spend that money and in doing so increase demand for products and services. Economists also note that if higher wages result in increased productivity, prices may not rise as much or at all.
6. Monetary and fiscal policies
The Federal Reserve is tasked with maintaining monetary policy in the US.
In periods of high inflation, it attempts to lower the rate through contractionary monetary policy by increasing interest rates, increasing bank reserve requirements, and selling government securities. When the economy is facing or in the midst of a downturn, the Fed initiates expansionary monetary policy by lowering interest rates, decreasing bank reserve requirements, and buying government securities. Failing to maintain balance between these two policies can lead to inflation.
In addition to monetary policy imbalance, certain other government policies can result in cost-push or demand-pull inflation. For example, when the government issues tax subsidies for products (i.e., solar panels), that can increase demand and result in demand-pull inflation. Regulations that increase costs for manufacturers could create cost-push inflation.
Economists also point to the potential inflationary effect of unexpected changes in the economy, especially as it relates to the supply of money. This is based on the idea that if everyone expects inflation due to the increase of money in the economy, supply will have an opportunity to increase to match demand. An unexpected influx of cash doesn’t allow the supply side to catch up, resulting in inflation.
Expectations of inflation can follow the same path. When people anticipate higher inflation they can bargain for higher wages to help offset the increased cost of living. This can lead to businesses raising prices higher causing what’s known as a wage-price spiral. This phenomenon is rare.
How does inflation affect consumers?
“When prices are rising quickly, many of us consciously – or subconsciously – make different choices in our lives, budgets and portfolios,” says Cox. “We revisit our budgets, cut our discretionary spending, and make personal sacrifices to make sure we can afford what we need. These small changes amount to big decisions, like renting instead of buying a house, choosing one job over the other, or moving cities for better opportunities. Suddenly, your life looks dramatically different. Collectively, the economy suffers from a ‘paradox of thrift’ – a shift toward savings that ultimately drags on growth.”
DeRitis points to large differences across socio-economic groups when it comes to the impact of inflation.
“Higher-income households have been more insulated from the effects of inflation, given that most own their homes with long-term, fixed-rate mortgages that are not affected by rate increases. Lower-income households have been much more exposed to inflation, given that they tend to be renters and spend a disproportionate share of their incomes on necessities including housing, utilities, food, and gasoline.”
How to protect your spending power from inflation
There are a variety of common-sense ways to help mitigate the impact of high inflation. DeRitis suggests the following:
- Reduce discretionary spending.
- Put off major purchases.
- Repair automobiles and other major items to extend their life.
- Consolidate credit cards and high-interest loans.
- If it’s an option, reduce housing expenses by living with family or having roommates.
- Find a job closer to where you live to reduce commuting costs.
- Increase income with a new job or a second job.
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As far as investments are concerned, Cox says: “The most important thing investors can do right now is revisit their ‘why.’ Understand when and why you need your invested money, and how much risk you can take on to reach that goal.”
Cox further advises that you consider investing in sectors that tend to thrive during inflation because they include things people will buy no matter what including food, energy, and medicine.
DeRitis suggests directing long-term savings toward assets that tend to rise in value along with inflation such as real estate, high-quality stocks, or inflation-protected US Treasury bonds (TIPS).
The keys to financial survival during inflationary times, then, are to reduce spending and expenses, increase income if possible, and put your money in inflation-friendly investments.