Most of us may know that inflation has something to do with economics and money. We may even know how inflation is defined: rising prices throughout the economy. However, you may still be left wondering what causes inflation?
Inflation is caused by several factors, but is mainly triggered by increased production costs and increased demands for goods.
These are the two main contributors to inflation, however there are even more factors at play. Inflation affects everyone, so read on to fully understand the entire process.
Inflation Causes: Cost-Push Inflation
This type of inflation takes place as production costs increase. As these costs rise, the result is increased prices for goods. Production costs include factors such as:
- Raw materials
- Labor
- Overhead
Production costs can also be increased due to unpredictable events like natural disasters, which take a toll on businesses.
Cost-push inflation can also happen when supply levels decrease. So, even if production costs remain stable, if supply levels drop, cost-push inflation can take place.
Raw Materials
Raw materials can include any material that goes into the production of goods that a business is producing.
When the costs of raw materials increase, businesses raise the prices of the product made with that material to make up for the higher material prices.
For example, if the price of lumber went up, all businesses that used lumber in their production would raise the prices of their product, resulting in Cost-push inflation.
Labor
Increases in labor costs can also create scenarios where cost-push inflation occurs.
This is especially true during times of economic prosperity when the unemployment rate is low. During these times, businesses may need to pay workers more, since there is less of a demand for jobs.
This increased labor cost can eventually lead businesses to raise prices, creating inflation.
Overhead
Any expenses or costs that come from the day-to-day businesses are referred to as overhead. These expenses can’t be linked to specific business transactions or activity, but instead are costs necessary to keep the business running smoothly.
Overhead is similar to raw materials, in that overhead expenses can hike up production costs and create inflation by forcing a business to raise its prices to cover the costs.
However, unlike raw materials, tracking the value of overhead expenses can be difficult for businesses, meaning it can be easy for overhead expenses to creep up and cause inflation.
Inflation Causes: Demand-Pull Inflation
The other chief cause of inflation is increased demand for a product. When there is a surge in demand for a product that a business cannot keep up with, it is known as demand-pull inflation.
As demand for a product increases, the product is bought up and supply decreases.
When this happens, higher demand and lower supply result in customers who are willing to pay higher prices for the product, and inflation occurs.
The economy is especially susceptible to demand-pull inflation when unemployment is low and consumers are spending more.
During these times, consumers are more willing to pay a higher price for products.
While a company could potentially raise the price of a product at any time, it is the consumer’s demand for the product that creates a sustained pattern of higher prices, which creates demand-pull inflation.
Inflation Causes: Alternative Factors
Although demand-pull inflation and cost-push inflation are the two central causes, there are plenty of other components that contribute to inflation, as well.
Devaluation
Devaluation is when a country’s currency loses its relative value.
If one country’s currency becomes devalued, it becomes harder to import goods from any other country, since that country’s currency isn’t worth as much, when compared to another’s.
If a business in a country with devalued currency needs to import goods from another country, devaluation could force that business to raise its prices in order to cover the costs of a more expensive import.
Increased Money Supply
The money supply is the total amount of money currently in circulation. If money is put into circulation at a faster rate than goods are produced, inflation will occur.
This happens, because the increased money supply causes consumers to buy more products than they were buying.
But, the businesses are still producing the same amount of goods as they were, since the amount of goods isn’t changing, only the money supply is.
The result is a form of a demand-pull inflation, where the demand for a product is caused specifically by the increased money supply.
Rising Wages
While wages are a form of production costs, there are times where businesses are forced to raise their wages by the government.
However, there is some debate over whether rising wages contribute to inflation.
Some argue rising wages cause cost-push inflation, but others list the following reasons for why higher wages should offset inflation:
- Higher wages might allow consumers to pay higher prices for products
- Higher wages may result in higher levels of productivity for a business
- Previous minimum wage increases did not correlate with instances of inflation
Inflation Expectations
Some experts believe that people’s fears about inflation can actually lead to inflation.
Workers who are scared of inflation and increased costs may ask for higher wages to offset the expected inflation. However, it may be their worries and expectations that are helping cause the inflation.
By requesting higher wages, they may be putting their business under strain and forcing them to raise prices.
Policies and Regulations
Government policies, such as tax subsidies for certain products, can also help lead to inflation.
If the subsidies give way to a significant increase in demand for those products, and the demand outpaces the supply, inflation may occur.
Additionally, stricter policies on businesses that make them pay more to operate normally may eventually be passed down to customers, who will now be charged higher prices, to offset the policies.
Conclusion
Whether it’s rising production costs creating cost-push inflation, a surge in demand causing demand-pull inflation, or one of the multitude of other factors, it can be difficult, but certainly not impossible, to understand and pin down the cause of inflation.
