Inflation affects everything around us, from basic necessities like housing, food, medical care and utilities to the cost of cosmetics and new automobiles. Furthermore, inflation can effortlessly deteriorate our savings. It makes the money saved today less valuable tomorrow, eroding our future purchasing power and even interfering with our ability to retire.
Central banks monitor inflation closely, as it is the overriding force behind monetary policies. These are the monetary policies that impact the level of money supply and the availability of credit within an economy. Central banks of developed economies, including the Federal Reserve in the United States, generally aim to keep the inflation rate around 2%. In this article, we will examine the fundamental factors behind inflation, different types of inflation and who benefits from it.
Causes of Inflation
Consumer Confidence: When unemployment is low and wages are stable, consumers are more confident and more likely to spend money. This confidence drives up prices as manufacturers and providers charge more for goods and services that are in high demand. One example is the market for new housing. In a booming economy, people purchase more new houses. Contractors experience greater demand for their services, and they raise their prices to capitalize on that demand. Similarly, the building materials included in the houses also cost more as supplies dwindle and consumers increase what they are willing to pay to complete the project. (For related reading, see: How Inflation and Unemployment Are Related.)
Decreases in Supply: One of the basic causes of inflation is the economic principle of supply and demand. As demand for a particular good or service increases, the available supply decreases. When fewer items are available, consumers are willing to pay more to obtain the item. Supply decreases for several reasons. Oftentimes a natural disaster or environmental effect is at fault for a supply-chain interruption, such as when a tornado destroys a factory or a severe drought kills crops. Supplies also decrease when an item is immensely popular, a phenomenon that frequently is seen when new cellphones or video games are released.
Corporate Decisions: Sometimes inflation happens naturally as supplies decrease and demand increases, but other times it is orchestrated by corporations. Companies that make popular items frequently raise prices simply because consumers are willing to pay the increased amount. Corporations also raise prices freely when the item for sale is something consumers need for everyday existence, such as oil and gas.
Decisions made by business owners can cause inflation even when it wasn’t the intended effect. Farmers often decide to thin their cattle herds when the price of feed increases. That decision saves the farmers money, but it means that less beef is available for sale, driving up the price and sparking inflation. (For related reading, see: Inflation’s Impact on Stock Returns.)
How Inflation Rates Are Determined
The inflation rate is determined by the rate of change in a price index. The most cited and analyzed price index in the United States is the Consumer Price Index for All Urban Consumers (CPI-U), which is released by the Bureau of Labor Statistics each month . The Consumer Price Index for All Urban Consumers is a weighted basket of goods and services, ranging from food and beverage to education and recreation. A second, often-quoted price index is the producer price index (PPI), which includes things like fuels and farm products (meats and grains), chemical products and metals. The producer price …