Causes of Economic Inflation and What You Should Know

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Chances are, you’ve been to the gas pump or the store and suffered from sticker shock lately. If you’re wondering if inflation plays a part, you’d be absolutely right. 

Economic inflation is caused when an unusually high demand for products, housing, utilities, food, and other daily necessities leads to a shortage of supply. Prices to produce these products go up as needed materials and resources grow scarce. This makes things more expensive for consumers. 

It’s a snowball effect of the worst kind. 

And that pandemic thing we’ve all been dealing with has primed the U.S. for the perfect inflation storm. As more and more people sat at home bored out of their minds, online shopping and large-ticket purchases soared. 

Consider one such company – Peloton. As millions of Americans were kept out of gyms, they turned to this giant workout conglomerate. People purchased so many bikes from the company that it couldn’t get them shipped overseas fast enough. 

So the company resorted to spending extra money to fly its equipment overseas instead. This cost Peloton millions and the costs were mostly likely passed on to the consumer in one way or another. 

The Primary Causes of Inflation in the U.S.

A strong economy with free-flowing cash can actually backfire. While it’s nice to have extra spending money on hand, too much of it can lead to supply issues and expensive production costs. Not to mention price hikes from companies that would like to profit.  

U.S. inflation can be caused by: 

  • Increased demand for products
  • Spending habit changes due to big events like pandemics or natural disasters
  • Scarcity of materials for producing in-demand goods
  • An excess of currency flowing through the economy which encourages spending
  • Increases in wages that could throw spending out of balance with supply
  • Price hikes by companies that would like to profit from the spending frenzy

Other things can contribute to inflation in the U.S. as well. A few of these causes aren’t top of mind when we think about why prices are rising all around us.

Extra money flowing to consumers via government stimulus payments can lead to deep pockets for some — who are then able to spend more freely than they might have before. 

Meant to help people through the sting of shutdowns and job losses, stimulus payments were crucial for some people’s survival. But others used the cash to buy more stuff, thus putting a strain on supply. 

Add stimulus money to the commuting and entertainment savings everyone enjoyed while working from home, and you’ve got a recipe for a spending frenzy, for sure. 

The Primary Types of Inflation

Most of us are familiar with the kind of inflation where increased buying leads to higher prices, but there are actually three primary types of inflation to be aware of:

  1. Demand-pull inflation
  2. Cost-push inflation
  3. Built-in inflation

Characteristics of demand-pull Inflation

Demand-pull inflation is a type of inflation that happens when there is more demand for goods and services than what can be produced at that time. This happens when the economy is doing well and people have money to spend.

Businesses normally have to increase prices to slow down buyer behavior so they can try to meet the demand. The main characteristic of demand-pull inflation is rising prices.

Characteristics of cost-push inflation

Cost-push inflation happens when the cost of production goes up and businesses have to pass (or “push”) these costs along to consumers in the form of higher prices.

For example, if the cost of wheat goes up and producing bread becomes more costly for the bread company, the price for a loaf of bread will increase to help with those added expenses.

This type of inflation is often caused by factors beyond the control of businesses or individuals, such as natural disasters or an increase in the price of imported goods. The main characteristic of cost-push inflation is also rising prices.

Characteristics of built-in inflation

Built-in inflation is like a continuous circle of cost-of-living and wage increases. As life becomes more expensive, workers require raises to keep up.

As these wages increase, the companies having to pay out more must raise their prices to be able to survive that added expense. It’s not necessarily linked to demand but simply the high cost of living. 

When businesses are required to raise their minimum wage, the employees are happier — until prices begin to reflect that added expense businesses must absorb.

The main characteristic of built-in inflation is rising prices, but it can also lead to lower unemployment because businesses have to hire more workers to keep up with production.

Measuring Inflation by Speed 

Not everyone agrees with measuring inflation by the traditional “type” above. Some economists gauge and define inflation by its speed

  1. Creeping inflation: mild inflation of around 2%, which the Fed tries to maintain for optimal economic stability/growth. 
  2. Walking inflation: strong inflation at a rate of 3-10% — characterized by crazy buying habits, supply problems, and prices most people can’t afford. 
  3. Galloping inflation: catastrophic inflation of 10% or more ,which leads to crumbling economies and the loss of credibility with foreign investors. 
  4. Hyperinflation: an extremely rare event where prices grow out of control — most often caused by excess printing of money during extreme circumstances such as war. 

Fiscal Inflation Factors

Sometimes government policy, currency flow and value, and interest rates contribute to inflation. They can also be used as measures for correcting inflation. 

Fiscal measures that affect inflation:

  1. Monetary policy
  2. Fiscal policy
  3. Exchange rates

How Can Monetary Policy Affect Inflation?

Monetary policy is governed by a central bank, such as the Federal Reserve System in the United States. Its policies control the availability of money and credit to help promote national economic objectives.

Much like Gringotts Wizarding Bank in Harry Potter, the central bank stays independent from political influence and is free to make its own policy.

Although not run by goblins, the U.S. central bank (or “Fed”) is definitely an entity unto itself — if not a little secretive and unpredictable.

The Federal Reserve’s policy can affect inflation by controlling the money supply. If the money supply grows too quickly, inflation can result. The Federal Reserve can also affect inflation by setting interest rates

If rates are too low, spending can increase and cause inflation. When rates are raised, spending is discouraged and inflation can often be curbed over time. 

How Can Fiscal Policy Affect Inflation?

Fiscal policy comes from the government itself. Our economy can move in various ways depending on tax policies, amounts of government spending, and what programs they’re spending on.  

Government policies can have an indirect effect on inflation by influencing economic growth. For example, if the government cuts taxes or gives cash bailouts, it can give a boost to the economy and lead to higher growth.

However, too much growth can lead to inflation if consumer spending outpaces how quickly companies can produce the goods and services in demand. 

On the other hand, the government can slow economic growth and lower inflation by raising taxes and cutting its spending on programs that infuse the economy with extra cash. 

How Can Exchange Rates Affect Inflation? 

Exchange rate fluctuations affect how much you pay for imported goods. If your currency is worth a lot, you’ll shell out less money for goods because your buying power is higher. 

On the other hand, when currency is devalued, the price of imported goods feels higher because it takes more currency to buy it. Exchange rate is simply how much buying power your money has at the moment. 

When you have greater buying power, import pricing is cheaper and means lower inflation. But when your money doesn’t go as far, the stuff you’re importing takes more of your money to get it, and those higher prices can raise inflation. 

The Relationship Between Inflation and Other Financial Aspects

Inflation affects a lot of our lives as consumers and can cause many disruptions and/or profits for businesses as well.

From how much we earn to how much house we can afford and even how well employed we are — the rate of inflation has a hand in most of it. 

How does inflation affect interest rates?

When prices are up across the board, due to tons of consumer spending and not enough supply, the economy may need a cooling-off period. This is when the Fed may take center stage. 

When inflation is getting out of hand, the Federal Reserve bank will implement a raise in interest rates. By making it more expensive to get loans, mortgages, car loans, etc.,the Fed can make people slow down their buying and save more money. 

This gives supply chains a chance to replenish and allows prices to stabilize as demand goes down. Higher interest rates can also cool off a hot housing market.

When the housing supply can’t keep up with high demand — some of which may stem from really low interest rates — there’s fierce competition and pricing wars. 

As people compete for houses in desirable areas, offers go far beyond asking prices. This throws that entire market out of range for the average hopeful homeowner. 

If the Fed raises interest rates, and suddenly that mortgage isn’t so cheap anymore, housing demand (and hopefully prices) has a chance to stabilize. 

Learn More:

How does inflation affect unemployment?

As a general rule, when an economy is jamming along and consumers are spending a lot, companies may need to hire just to keep up with demand. This can definitely lower unemployment. 

But don’t get too happy. Inflation can also lead to high production prices, which puts a strain on company finances. Therefore, layoffs and hiring freezes can result. 

So inflation and people’s spending habits can cause unemployment to go either way. 

One of the trickiest things to figure out is how to cool off inflation a bit without causing a loss of jobs through inflation’s evil twin, recession. 

If interest rates are set too high, people get scared and won’t buy much, and that can result in companies having layoffs because they’re not making enough to keep afloat. 

It’s a delicate tightrope to balance, for sure. 

How does inflation affect consumer spending?

Or maybe it’s “how does consumer spending affect inflation”? Which comes first, the chicken or the egg?

An overexcitement for spending can lead to drastic price increases due to a struggle to meet demand — especially if there’s a shortage of materials used to produce the stuff everyone’s trying to buy. Remember the Peloton example? 

These shortages can have quite an effect on the amount people will spend as well. 

Since there’s not enough to go around, consumers are willing to pay premium prices, thus the spiral of inflation marches forward. 

Pretty soon, prices are so high that spending must cool off or everyone will be broke. 

The federal bank often steps in to give the people a little help in curbing their spending. They hike the interest rates and — viola! — consumers spend less (at least that’s the goal). 

The Consequences of Inflation

Whether good, bad, or neutral, there are always consequences when inflation gets out of balance. Does that mean some inflation can be a good thing? 

Yes, a bit of inflation will keep an economy moving forward and prevent stagnation, weakening of the dollar, encourage people to save, etc. 

In fact, most economies shoot for a rate of about 2% inflation to stay in a healthy range of growth versus recession. 

When can inflation be a sign of a prospering economy?

Inflation can be a sign of a prospering economy when it is caused by economic growth. Good signs of growth are profitable businesses, people who are earning decent wages, and spending that’s at a good pace. 

If pricing for goods is in the moderately-high range, and exports remain strong, this is a recipe for a country to grow its wealth. A strong economy is founded on its earning power. 

A prospering economy also has more money in circulation. Whether consumers are sending more into the fiscal universe — or the government is infusing some cash — strong currency circulation is a sign of strong economic growth. 

How can inflation affect the value of long-term savings?

Inflation can drastically cut into your future purchasing power if you don’t watch your savings growth carefully. The interest you earn on your savings needs to keep up with inflation. 

This is one very good reason not to put the bulk of your hard-earned money in a traditional savings account. Bank interest rates don’t come close to keeping up with inflation. 

By not earning enough interest on your savings and investments for the future, your dollars won’t buy as much down the road. 

Since prices are always on the rise over time, today’s dollars wouldn’t buy nearly as much in 10 years. 

To protect long-term savings during inflation:

  • Don’t keep the bulk of your money in accounts that don’t earn much interest.
  • Make a point to save more if you can: implement frugal spending habits
  • Diversify your savings and investments to safeguard them from inflation fluctuations. 
  • Maximize your future purchasing power with interest rates that grow your wealth and outpace the rate of inflation. 

Learn More:

How does inflation affect the stock market?

When inflation is high, the  value of money goes down. People have to spend more money to buy the same things. This makes it harder for businesses to make a profit, so they might reduce their stock prices to try and attract buyers.

Lower stock prices can lead to a decrease in the value of investments, which can cause people to lose money. When stock prices are up, it’s worth more. When prices drop, stock is worth less. 

Although many people shy away from the market when inflation hits, some investors consider it a prime time to buy

However, a common practice during inflation booms is an uptick in purchases of assets such as precious metals and bonds because they retain their value better in an uncertain economy.  

The Bottom Line

Inflation is definitely not a simple phenomenon. It can be good, bad, or just plain ugly. Moderate inflation signals that an economy is strong and growing; we like that. 

High inflation causes extreme price surges and production disruptions. Sometimes the Fed must implement measures such as raising interest rates to cool things off. 

When inflation strikes, your finances need extra care. Make sure your savings stay strong and invest with strategies that outpace inflation for a strong future. 

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