Inflation: What You Should Know

Inflation: What You Should Know
Man looking at a receipt after shopping. | Image by Elena Perova, Getty Images

Inflation is the decline of a given currency‘s purchasing power over time. It reflects the increase in average price levels for a particular basket of goods and services within an economy. An increase in money supply is the root of inflation, though this can play out through different mechanisms in the economy.

According to Dorothy Neufeld with Markets In A Minute, the way to visualize the different types of inflation are through monetary inflation, consumer price inflation, and asset-price inflation.

Monetary inflation occurs when the U.S. money supply increases over time. Money supply increases are represented by physical and digital money circulating in the economy, including cash, checking accounts, and money market mutual funds.

The U.S. central bank typically influences the money supply by printing money, buying bonds, or changing bank reserve requirements. The central bank controls the money supply to boost the economy or tame inflation and stabilize prices. Between 2020 and 2021, the money supply increased roughly 25% — a historical record — in response to the COVID-19 pandemic. Since then, the Federal Reserve has begun tapering its bond purchases.

Consumer price inflation occurs when the prices of goods and services increase. It is typically measured by the Consumer Price Index (CPI), which shows the average price increase of a basket of goods, such as food, clothing, and housing. 

Supply chain issues, geopolitical events, monetary supply, and consumer demand may all affect consumer price inflation. Rising 8.6% in May year-over-year, the CPI hit its highest level in four decades. Russia’s invasion of Ukraine and COVID-19 has caused extensive supply chain disruptions, from oil to wheat, leading to increased price pressures worldwide. When consumer price inflation gets too heated, like it is today, the central bank will raise interest rates to curtail spending and allow prices to cool down.

Asset-price inflation represents the price increase of stocks, bonds, real estate, and other financial assets over time.

While there are several ways to show asset-price inflation, Neufeld cites household net worth as a percentage of GDP. Often, a low-interest-rate climate creates a favorable environment for asset prices. Over the last decade, this climate can be seen as low borrowing costs were met with rising asset prices and strong investor confidence. In 2021, household net worth as a percentage of GDP stood at 620%. Sometimes rising asset prices can be a misleading sign of a strengthening economy since no actual output is produced. Instead, this may indicate an asset bubble.

According to Investopedia, the mechanisms affecting inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation. 

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy’s production capacity. Demand increases lead to rising prices, creating a demand-supply gap with higher demand and less flexible supply, resulting in higher prices.

Cost-push inflation occurs when the cost of producing products and services rises, forcing businesses to raise their prices. Cost-push inflation leads to higher costs for the finished product or service and works its way into increasing consumer prices. For instance, when the money supply expansion creates a speculative boom in oil prices, the energy cost can increase and contribute to rising consumer prices.

Built-in inflation is sometimes referred to as a wage-price spiral and occurs when workers demand higher wages to keep up with rising living costs. This, in turn, causes businesses to raise their prices to offset their rising wage costs, leading to a self-reinforcing loop of wage and price increases. As the price of goods and services rises, workers and others come to expect that they will continue to grow in the future at a similar rate and demand more wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

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1 Comment

  1. Scot Walker

    “COVID-19 has caused extensive supply chain disruptions”

    “The lock down has caused extensive supply chain disruptions”

    Fixed that for ya.


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