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What Is Inflation, and What Causes It?

Ruby Layram Finance Editor Author expertise
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Many staples that we use every week have become costlier. For example, the cost of gas, groceries, and utilities have all increased noticeably. Although headlines often focus on inflation’s effects, they don’t answer the fundamental question of what inflation is.

Inflation can often lead to higher prices for goods or services due to scarcity, high demand, or problems in the supply chain. In some cases, the combination of all these factors can cause inflation. Understanding the causes of inflation and how it affects your investments and finances can help you monitor changes in your finances.

What is inflation?

Inflation refers to a general increase in the price of goods, and corresponding falls in the value of money. Another way to define inflation is “too many dollars buying too few goods.” To measure price fluctuations, most economists use a “basket of goods” — a collection of general products with their prices. The Consumer Price Index, which measures inflation rates, can then be calculated from this basket of goods.

The CPI measures the price changes. Understanding how prices change can help you to understand consumers’ purchasing power. In addition, the difference in income and expenses can help you better understand the standard of living in a certain area. Higher inflation rates mean that it will be more difficult to maintain a decent standard of living.

What is the cause of inflation?

What causes inflation? There are many causes of inflation. These include supply shortages and higher demand, an increase in the price of a product/service for which there is no substitute or changes in wages that result in subsequent price rises. 

These are the three most common causes of inflation: demand-pull, cost-push, and built-in inflation.

Demand-pull inflation

Supply shortages cause demand-pull inflation. When consumers or businesses are able to purchase more than the available number of items, their cost will rise. For example, if less lumber is available due to high demand, buyers may expect to pay higher prices for what’s still in stock. Likewise, you may end up spending more on renovations and construction due to high demand.

Cost-push inflation

Cost-push inflation is when the cost of an essential product or service rises when an alternative is not available. If oil prices rise, for example, it is likely that you will pay more per gallon of gas because there is no alternative.

Cost-push inflation can also occur if the money supply is higher than the demand. For example, a country with too much cash may experience a loss in value, which can affect a consumer’s purchasing ability.

Built-in inflation

Built-in inflation refers to the added expenses that buyers have to pay due to higher wages. Employers often pass on higher wages to employees. For example, restaurants that offer a 5% wage rise to their employees may raise the prices of menu items in order to maintain the same profit margin.

Inflation effects

Consumers can be affected by inflation in many ways. Most of these effects adversely impact consumer savings and purchasing power. Economists predict that inflation and Fed policies will lead to the following outcomes for consumers:

  • Your liquid savings lose value.
  • Fixed-rate investments produce more value slowly.
  • You might need to revaluate your budget if your purchasing power is declining.
  • Fixed-rate mortgages can charge lower interest than variable or new fixed-rate loans.
  • To curb spending, the Federal Reserve could raise interest rates which can increase inflation.

Inflation hedging

There are many ways to handle inflation, and inflation hedging is one of them. Inflation hedging assets or techniques may be of interest to investors concerned about rising inflation. Inflation hedging is investing in assets with low or negative correlations to industries or investments that are negatively affected by high levels of inflation. These investments can help reduce stock market losses due to inflation.

Inflation-hedging investments that are well-suited for real assets are more common than those made from real estate. 

In addition, gold and other precious metals can be used to hedge against inflation. Some commodities see an increase in their price during periods of inflation, so they can be considered for investors.

It’s important to monitor inflation, but it’s equally important to look at the larger picture before making investment decisions. Talk to a financial professional if you are unsure how inflation may affect your finances. This will allow you to create a strategy that maximizes your profits.

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Ruby Layram Finance Editor

Ruby Layram Finance Editor

Ruby is a Finance Editor who has 5 years of experience in the finance and cryptocurrency space. Ruby attended the University of Winchester where she received a BSc in Psychology. During her studies, Ruby developed an interest in financial psychology and began writing content around the topic on a freelance basis.  Whilst she was studying for her degree, Ruby spent time learning about personal finance, investing and trading. She has written content for The Motley Fool UK, Bankless Times and Cryptonary where she also worked as an editor. Her interest in cryptocurrency came about after writing a piece for The Motley Fool about the rise of CBDCs. Since then, Ruby has actively invested in the crypto market with a focus on long-term investing.  Ruby is also an experienced trader with good analytical skills. She has used a used a variety of platforms and tools to trade and has first-hand experience with many of the platforms that are featured on the Trading Platforms website.