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What causes inflation? | Family finances

Hyperinflation can be extremely detrimental to consumers, but deflation is also considered undesirable by economists. The causes of inflation – and how severely the factors that trigger inflation affect consumers – vary and have historically been much discussed among economists.

However, the existence of inflation itself is expected.

“Inflation is normal,” said Brian O’Leary, wealth adviser and senior analyst at ALINE Wealth. “We do not have to fear that inflation exists, and in fact it is healthy in the economy. The question is what amount of inflation is appropriate. “

What causes inflation?

Inflation is caused by factors such as pressure on the supply or demand side of the economy, money supply policies and even consumer expectations.

Economists define inflation as the rate of increase in prices over a given period. It is typically a general measure that refers to the overall increase in prices or cost of living in a country. The reasons may vary, but rising prices in a particular sector do not necessarily indicate broad inflation.

“The price of a particular item going up or down is not inflation,” says Michael Rosen, chief investment officer at Angeles Investment Advisors. “Inflation is caused by an imbalance between supply and demand of money, not the imbalance between supply and demand of a particular commodity, such as the price of a plane ticket or the price at the pump.”

Today’s high inflation was partly caused by factors related to the coronavirus pandemic. The consumer price index rose only 2.3% from 2018 to 2019 – close to the Federal Reserve’s inflation target of 2%. But as the economy began to recover from the effects of the pandemic and after various government efforts to stimulate the economy during the pandemic, the annual CPI hit 8.5% in March.

“We had a period of one and a half years where people were mostly locked inside their houses and saving more than usual,” says Gary Zimmerman, managing partner of Six Trees Capital in New York and founder of MaxMyInterest.com. “Now they want to go out and spend, and they are willing to spend more. Until that news disappears, or until prices rise to the level where it really starts to affect demand or consumption, we will continue to see pretty high levels of inflation. “

Types of inflation

Periods of inflation can occur unexpectedly as a result of global events, such as the pandemic or the Russian invasion of Ukraine. But there are generally three types of inflation:

  • Demand-pull inflation.
  • Cost-push inflation.
  • Built-in inflation.

Demand-pull inflation is characterized by an over-demand in the market, which supply can not meet in parallel with low or declining unemployment. This type of inflation is often caused by rising wages, rising house prices and low interest rates.

Cost-push inflation are characterized by higher raw material prices and are often caused by high production prices or high costs associated with raw materials.

The third common type of inflation is associated with consumer expectations.

“People are beginning to recognize that inflation is more than transient, and that in itself is important because inflation can continue on its own,” Zimmerman said. “If there is a perception that inflation is temporary, then suppliers and retailers will be reluctant to raise their prices, but once the narrative has evolved to ‘inflation has come to stay’, it gives companies and their supplies coverage to start raising prices. ”

How governments respond to inflation

Central banks are often tasked with maintaining price stability. For example, the Federal Reserve has so far responded to today’s high inflation rates by raising interest rates by 0.25% in March in an attempt to cool an overheating economy.

Governments have a number of levers to pull when trying to control inflation. Contracting policies aimed at reducing the rate of inflation include raising interest rates, fixing the exchange rate by tying the value of one currency to another, and pricing measures.

One of the most cited historical examples of governments trying and – in many ways failing – to control inflation, is the period of the 1970s and 1980s, known as the Great Inflation. During this period, inflation hit as high as 13.5% year over year.

There was considerable debate at the time, Rosen says, about the causes of inflation and how best to respond, mimicking the conversations being held about inflation today.

“There was a lack of the basic understanding that supply and demand are what really lies behind inflation, and one sees the same kind of discussion today,” Rosen says. “It’s hard to quite formulate with the data how terrible the economic conditions were in the 1970s and 1980s for almost everyone. We are not even close to these conditions today… But what looks like is a Federal Reserve that has been slow to tighten policies and tighten the money supply in the face of rising demand. ”

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