What Causes Inflation?

Recently, I wrote a little bit about inflation. Specifically, I wrote about why the Federal Reserve is so worried about inflation, and why good economic news and inflation often seem to go hand in hand. That led to some questions about what inflation is exactly and where inflation comes from.

What Is Inflation?

Perhaps, it is best to start at the beginning with a definition of inflation.

Inflation defined is,

The rise in prices of goods and services when spending increases relative to the supply of the market.

In other words, when prices rise because spending, by business, or consumers, or both rises.

Where Does Inflation Come From?

Pinning down exactly what causes inflation can be tricky. Inflation is a simple word applied to a very big concept that encompasses a lot of how a market economy works.

For starters, inflation is natural. This may come as a shock considering how much the Fed and the media harp on keeping inflation down. However, inflation is inevitable as long as the population within an economy is growing, as is the natural state of the human race.

Consider a small tribe with a fully modern monetary economy. Let’s say that there are 100 of us. For total simplicity, lets say that each of us earns $100 per week and that we each buy one egg per week. Each egg costs $1, and at that rate, the farmer can sell all 100 eggs his chickens produce.

Now, let’s say that someone moves to town. Like all of us, he earns $100 per week and also would like to eat one egg each week. However, there are only 100 eggs and now there are 101 customers. At this point, the farmer can raise the price of an egg until one person refuses to pay that amount and the supply once again matches the demand. As long as there are 101 people and 100 eggs, this pricing dynamic will not change back. That is inflation.

Note that if a chicken dies, and prices increase, that is NOT inflation so much as a temporary (we hope) constriction in supply. Only if the price of eggs rises and stays there over a period of time can we consider it inflation. This leads to the even more difficult question of how inflation is measured.

The government uses several different statistics to measure inflation as it relates to the cost of living. One of these metrics measures “core” inflation, which deliberately leaves out things like gasoline that vary in price more due to temporary changes in supply or demand than they typically due to inflation.

There are numerous cost of living indexes that economists routinely argue over.

Higher Wages Can Trigger Inflation

In our above example, inflation was caused by an additional person permanently increasing the demand for goods and services in our economic system. This happens every day when more people are born than pass away. It is the reason that inflation only moves in one direction over the long-term, although deflation may occur in the short term.

Another potential cause of inflation is an increase in wages. This is the primary argument against raising the minimum wage.

Increasing wages cause inflation in two ways. First, higher wages means more money. That means that you simply CAN pay more for an egg than you used to. If enough people are willing to pay more, why wouldn’t the farmer charge more?

The second way higher wages cause inflation is that the employer still must make a profit to stay in business. If payroll increases from $50,000 per month to $55,000 per month, it may be possible to just have a slightly lower profit that month. However, if payroll increases significantly, then the only way for the business to continue to earn the same amount of profits is to earn more money. If the business can do so by increasing sales, but not raising prices, then no inflation occurs. However, if the business must raise prices to make payroll, then the cost of goods increases and inflation occurs.

What Is Not Inflation

One of the most difficult facets of inflation is understanding what is NOT inflation. Prices rise and fall all of the time based upon supply and demand. Furthermore, seasonal goods and services will be more or less valuable at certain times. For example, air conditioner repair may be cheaper in the winter. Gas is often more expensive in the summer when more families drive further than usual for vacations. Seasonality occurs in other ways too. Prices on some goods fall in anticipation of the holiday shopping season, for example.

In the end, inflation is really on the long-term, if not permanent, increase in prices. Fifty years ago, you could have bought a house for what a car costs today. That won’t change just because it’s winter. The real goal for inflation then, is to keep it under control. That happens when the economy grows at a “normal” rate. However finding and keeping that normal rate is where all the difficulty lies.

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