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What is Inflation?

What is Inflation?

Unless you are independently wealthy, you’ve noticed that your money isn’t going as far as it used to, with the cost of everything from bread to gas to used cars to entertainment rising an average of 7.5 percent this year alone1. Some goods and services have risen much higher than that, like rent, which rose over 14% on average nationwide from 2021-20222.

Your paycheck, meanwhile, likely hasn’t seen much of a change, meaning that you may be living a little differently – eating at home more, doing without some of the things you used to enjoy, overusing your credit card, or dipping into your savings. And what’s the culprit? Inflation. You’ve almost certainly heard the term, but what is inflation?

What is Inflation?

The price of lumber and beef may go up, but the cost of most other goods in the economy remain stable. That is not inflation. On the other hand, when prices increase across the whole of the economy over a specific period of time, even if at different rates, that is the classic definition of inflation. Inflation means the purchasing power of your money is diminished because of the widespread hike in prices for goods and services, especially when salaries are not increased at a rate that covers the rising costs. 

What are the Causes of Inflation?

There are a number of economic factors that can contribute to or cause inflation, but they all stem from an increase in the quantity of money available, or circulating, in the economy. Some of these factors are universally accepted as having a causal effect on inflation, while others are widely debated. What are the causes of inflation? Here are some of the more commonly agreed upon ones.

  • Demand-Pull Inflation

More money = more buying power. More buying power = more demand for products and services. When there is a greater demand for goods and services than the supply available, prices are “pulled” up because of a business’s inability to quickly produce enough to meet the demand, making the products that are available more valuable (expensive). This price increase can be temporary or may last long-term, depending on the time it takes to restore demand/supply balance. Other factors that can contribute to demand-pull inflation include rising wages, falling unemployment, rising house prices, and low interest rates.

  • Cost-Push Inflation

In cost-push inflation, the demand for a product or service remains steady (doesn’t decrease), even when producing those products or services becomes more expensive, perhaps due to the increased cost of manufacturing, energy, raw materials, or skilled labor. As a result, businesses must “push” those costs on to the consumer. If enough businesses are affected by the higher prices, then the economy experiences cost-push inflation.

  • Built-in Inflation

Built-in inflation is much like a self-fulfilling prophecy. When consumers and businesses believe that current inflation isn’t going away, or that the rate may go even higher, they begin to adjust their expectations. Workers demand higher salaries to compensate; higher wages force businesses to raise the cost of their products or services; and the cycle begins to perpetuate itself.

  • Devaluation

When excess money is put into the economy, whether by governments printing and dispensing money to individuals, legally decreasing the value of the currency, or, more commonly, giving too many loans, the increased flow of currency decreases its value on a national and international scale. This results in a rise in the actual cost of goods and services. In other words, when a country’s money supply grows faster than the economic growth of the country under normal circumstances, inflation ensues. If the difference between the money supply and economic growth becomes big enough and happens fast enough, it can lead to hyperinflation – when inflation rises more than 50% per month.

After answering, “What are the causes of inflation?” the next obvious question is, “How is inflation measured?”

How is Inflation Measured?

The most widely used tool the government uses to measure inflation is called the CPI – the Consumer Price Index. This index is used to compare the current prices of a set of goods or services to their prices at a particular point in the past, which tells how quickly and how extensively the prices are changing in particular sectors and in the economy as a whole. The primary index is an average of price changes experienced on 80,000 goods and services purchased by urban consumers, who comprise 93% of the U.S. population. These goods and services include everyday expenditures like food, cars, housing, energy, medical care, entertainment, and travel.

Developed by the Bureau of Labor Statistics, the CPI identifies which items to assess based on a survey of American households called the Consumer Expenditures Survey. Each item is given a different weight in the index based on its value to the consumer and its impact on the economy. Another measuring tool, the Personal Consumption Expenditures price index (PCE), uses a similar survey approach. However, the PCE measures the change in prices for all consumption items in the market, not just those paid for by consumers out-of-pocket.

The price variations for these indexes are usually recorded and reported each month to identify trends over a several month period. The BLS also compares the CPI in one month to the same month the prior year, giving a 12-month overview of cost variation.

The percentage changes in these indexes are how inflation is measured because they reflect the change in purchasing power of your money. The government also uses the CPI to adjust tax income brackets and social security/veteran benefits, as well as to assess if the country is entering, continuing, or coming out of an inflationary period. Based on the data, the central bank (the Federal Reserve) then controls the flow of money into the economy to either stimulate or slow it down, if necessary.

Is Inflation Good or Bad?

Hearing the word “inflation” can immediately cause a negative reaction. But when asking, “Is inflation good or bad?” the answer is actually - both. Good inflation is a low, steady rate that is necessary for a healthy economy because it encourages balanced borrowing and spending, which leads to economic growth of individuals and businesses. The healthy inflation rate identified by the Federal Reserve is currently around 2%. 

Inflation becomes negative when it rises above the healthy range, especially when it persists for several months and affects the GDP (gross domestic product) - the total monetary or market value of finished goods and services produced by a country in a specific time period. Some indicators that inflation is having harmful effects on the economy include wage increases not keeping up with price increases; higher production costs being passed down to the consumer; the fear of higher prices in the future causing excess consumer spending in the moment, which leads to a cycle of higher inflation; businesses spending disproportionately to operate, which leads to soaring unemployment and company failures; personal debt becoming excessive with overuse of credit cards; loans seeing higher rates of default; and too much money chasing too few goods that results in price increases.

Likewise, when prices begin to fall or stay the same for long periods, it’s easy to think this is a positive thing, but that may be misleading, as well. Known as deflation, this can hit the economy just as hard, sometimes harder, than inflation. Deflation can cause consumers to delay their purchases because they hope prices will fall further, which decreases demand. This causes businesses to drop their prices even more and possibly stop producing. They may also be forced to cut wages or lay off employees. Consumers then have less money to spend. Because the value of assets purchased during deflation goes down, they also don’t buy big ticket items like homes and cars. Unemployment rises and wages decline as demand drops and companies struggle to make a profit. Lower corporate profits cause stock values to fall. Banks are disincentivized to offer loans when interest rates bottom out at zero and when repayment rates are risky from lower-paid or unemployed borrowers. All of these effects are compounded as deflation persists and the economy stalls. 

Both inflation and deflation, when prolonged, can lead to recession, which is a slowdown in general economic activity. In macroeconomics, recessions are officially recognized after two consecutive quarters of negative GDP. Considered a part of the natural business/economic cycle of expansion and contraction, recessions occur after economies reach their highest point of growth and then start to recede. A deep recession that lasts for a prolonged period of time develops into a depression. 

A Career in Economics

Though inflation is currently the economic factor most intensely affecting our lives, it is just one aspect of the broader field of economics. If you would like to understand the primary issues that drive the economy and turn that into a stimulating career, Ottawa University offers an accelerated online Bachelor of Arts in Business Economics that will provide real-world insight into the decisions made by leaders in business and the impact those decisions have on society locally, nationally, and around the globe. 

The degree offers a solid starting point for advancement in a business or government position, as well as for graduate work in business, law, economics, and finance. Students can customize the economics degree to their preferences and skills by selecting a concentration in Finance, Human Resources, or Leadership and Management.

If you have a passion for solving business problems and a spirit for innovation, then OU’s business economics degree will build on what drives you naturally to prepare you for a long-lasting and fulfilling career in economics. Contact us today!


Posted: 01/10/2023
Updated: 01/10/2023 by OU Online
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