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What Causes Inflation in the Economy?

February 13, 2023

What causes inflation and why is it so high? Inflation is the rate of rising prices and a measure of the value of an economy's currency.

What is inflation, why does inflation occur, and is inflation a bad or good thing? Economics can be very complicated. There is a lot of new vocabulary to learn and a lot of complex concepts to understand. One of the basic economic terms everyone should know is the concept of inflation and what causes inflation in our economy.  

What is Inflation? 

Money has value and that value can fluctuate over time. When the value of a currency decreases that is called inflation. The answer to why is inflation bad is because inflation means that the value of a dollar has gone down, which decreases the purchasing power of everyday people. Inflation is often shown as a percentage rise in prices. 

The concept of inflation can feel confusing because you would think that a dollar is worth a dollar and that's it. But that dollar amount can go farther (or not as far) depending on the economy and inflation and deflation. For instance, when inflation is lower, you might be able to buy Item A with a dollar. But when inflation is higher, that same Item A might cost 2 dollars instead, meaning your one dollar doesn't purchase as much as it did before.

What is Inflation?

What is the opposite of inflation? 

The opposite of inflation is deflation. Deflation is when the purchasing power of a currency goes up instead of down. You can easily remember the difference between these 2 economic terms because inflation causes prices to rise and deflation causes prices to lower. 

Deflation can be caused by a decrease in the supply of money in an economy. It can also be caused by economic growth like an abundance of productivity as well as available goods or by a decrease in aggregate demand. 

Deflation Definition

How is Inflation Calculated?

Basically, inflation is calculated by organizations like the Bureau of Labor Statistics (BLS), the central bank, or the federal reserve. They monitor and track the prices of these many goods and services to compare prices from one year to the next. The difference in prices from one year to the next help us track inflation as a percentage and measure years that have lower and higher inflation rates.  

What is a basket of goods?

A basket of goods is a part of how inflation is calculated. A basket of goods is an economic term that refers to the goods and services used to record and keep track of price increases. For example, the BLS tracks the prices of goods for around 94,000 products. These 94,000 products are the "basket of goods" being used to calculate inflation by the BLS. 

Generally, the basket of goods used in this calculation are items that are most commonly purchased by the average consumer in an economy. This basket might include things like food, housing, clothing, and other essential and common items that most consumers are spending their money on. 

Basket of goods

The Consumer Price Index (CPI) Explained

The Consumer Price Index (CPI) is the name of the measurement of inflation occurring in the current economy. This CPI number is a measurement of the average change in prices over time, like a 12-month period for example. The BLS is one organization that gathers and calculates data to calculate the CPI of the US. 

The CPI is also divided into categories like All Items, Food, Energy, and All Items Less Food and Energy. 

What Causes Inflation? 

So, what causes inflation? What causes the value of a dollar to go down and what causes prices to go up? There are many potential causes for inflation. But one of the primary causes of inflation is an increase in the supply of money. The more money that exists, the less value each dollar has. 

This increase in supply effecting something's value can happen to many goods and services. If Item A is widely available; it is not as valuable. But if Item A is more rare, it becomes very valuable. 

But how does the supply of money grow? Most commonly, the supply of currency grows because the monetary authorities print more money. This can happen through printing more money, legally reducing the value of currency, or loaning new money into existence. 

This increase in money supply and how it causes inflation is defined by 3 types of inflation effects that help to answer the complex question, why does inflation occur? 

Why Does Inflation Occur?

  • Demand-pull effect (aka demand-pull inflation)
  • Cost-push effect (aka cost-push inflation)
  • Built-in effect (aka built-in inflation)

Demand-Pull Inflation

Demand-pull inflation, or demand-pull effect, is when demand for goods and services increases, causing the prices of those goods and services to also increase.

There is an aggregate supply (how much of a good or service is currently available) and then there is the aggregate demand (how much of a good or service is wanted or needed by consumers).

Aggregate supply and aggregate demand interact with each other, and when there are increases in demand that overreach the aggregate supply, an economy can end up with demand-pull inflation. 

Demand-Pull Inflation

Cost-Push Inflation

Cost-push inflation, or cost-push effect, is when the cost to produce goods and services increases, causing the prices of those goods and services to also increase. When a company has to pay more to produce the items they sell, this extra production cost raises prices for consumers as well. Higher prices for production lead to higher prices for the customers as well. 

Cost Push Inflation

Built-In Inflation

Built-in inflation, or built-in effect, is when the cost of living increases, causing wages to increase as well. Generally, workers want their wages to meet the cost of living where they live. When the prices of goods all around them increases, it can cause workers to expect or need their wages to increase as well in order to maintain their standard of living. 

But this can cause a cycle that feeds inflation. Price increases cause wage increases, which causes more price increases. 

Built In Inflation

Why is Inflation So High Right Now?

Inflation can be caused by many complex reasons working alongside each other to cause one effect—higher prices. Prices are on the rise right now and there are potentially 3 reasons for why this is. The increase in labor costs, the increase in energy prices, and higher interest rates could all be a part of what is driving higher inflation right now. 

In Conclusion,

Inflation is a complex economic concept. But understanding it better can help you understand the economy you live in better too. Understanding your economy can help you make more informed choices. Make more informed choices when you vote and interact more effectively with the economy around you. Make smarter investments and learn more about economic terms in our related articles below.  

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