Top 6 Causes of Inflation – Explained Simply

To make sure your money keeps up with inflation, you should save and invest your money whenever possible.
Rachel Mendelsohn / Inside

Inflation is the increase in the cost of goods and services over time.

The change in inflation is caused by a number of factors. For example, due to the increase in production costs.

Inflation is measured monthly using the Consumer Price Index.

From used cars to the real estate market to the stock market, inflation has always played an important role for people. Because if prices rise over time, the purchasing power of the euro slowly declines. However, the rise and fall of inflation can have different causes depending on the economic situation.

What is inflation?

Inflation is the increase in the price of goods and services over time. Inflation reduces your purchasing power. Meaning: with the same euro today you can buy less in the future.

“The simple story is that too much money is spent on too few goods and services,” says Dean Baker, chief economist at the Center for Economics and Policy Research in Washington, US.

The current inflation rate

Germany’s inflation rate reached 7.6% in June 2022, according to the Federal Statistical Office. To account for inflation, a ‘shopping basket’ of goods and services is first created. The “shopping cart” price level is what is measured from month to month. This basket of goods aims to obtain a portion of the goods and services that urban households typically consume. The CPI is generated from this basket and the present value of the basket is determined by summing the individual totals.

The next step is to compare the cost of the current basket with the same basket in the so-called base period. Then inflation is calculated from the change in the basket price level in the base period compared to the basket in the last period.

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What are the causes of inflation?

Inflation can be caused by various factors. The most common factors are demand side inflation and cost side inflation.

The following are the main causes of inflation:

1. Demand inflated

Demand-pull inflation occurs when the demand for certain goods and services exceeds the economy’s ability to meet that demand. When demand exceeds supply, there is upward pressure on prices, causing inflation.

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2. Cost inflation

Cost-push inflation is the rise in prices when labor and material costs go up. These costs are often passed on to consumers in the form of higher prices for those goods and services. An example is sawn lumber, as it is an essential product for home construction. When the cost of sawn lumber increased by 400 products in 2021, it affected property price increases and led to inflation.

3. Increase the money supply

The money supply is defined as the total amount of money in circulation, which includes cash, coins, balances and bank accounts. If the money supply increases faster than the rate of production, this can lead to inflation, especially demand and attraction inflation, where too many dollars are spent on too few products.

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4. Devaluation

Devaluation is a downward adjustment of a country’s exchange rate. This leads to a depreciation of the country’s currency.

A devaluation makes a country’s exports cheaper, which encourages foreign countries to buy more of the devalued goods. Also, devaluation makes foreign products more expensive for the devaluing country, which causes the citizens of the devaluing country to buy domestic products over foreign imports.

5. High wages

A wage rise is exactly what it sounds like – an increase in workers’ wages. “Wages are the cost of production,” Becker adds. When wages rise sharply, companies either have to bear the costs or live with low profit margins. The exception is when they can offset the wage increase with higher productivity.”

However, economists are divided over the effect of increased wage increases, such as raising the minimum wage, versus rapid and sudden wage increases. Some believe that higher wages can lead to costly inflation due to higher costs for businesses. Others believe that higher wages across the board, not just in certain sectors, also raise demand enough to offset the price increase.

“Rising wages should allow consumers to combat inflation, especially if wages are growing at the same rate or faster than inflation,” says Susan L. Tony, professor of business and economics at Hampton University. “Increasing wages allows consumers to pay higher prices without affecting their purchasing power.”

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6. Policies and Regulations

Certain policies can also lead to inflation on the cost side or the demand side. If the government provides tax subsidies for certain products, this can lead to increased demand. When demand is greater than supply, costs can increase. Moreover, strict building codes and even rent stabilization measures can inadvertently increase costs and create an inflationary environment by transferring these costs to residents or artificially reducing the housing supply.

Financial implications

Inflation, generally around 2 percent per year, is a normal part of our economic system. Under normal financial conditions, this means that your money is less valuable each year unless it multiplies at a rate greater than or equal to inflation. Annual increases or cost-of-living adjustments by your employer can ensure your money keeps pace with inflation.

“Remember, inflation tends to be uneven,” Becker adds. “Some prices go up quickly, while others may remain stable or even go down. This can be an opportunity to save money by waiting for better prices or finding an alternative item or service.” Investing your money is also an important tactic. Because the interest rates you get on your savings accounts “probably won’t cover the rate hike,” according to the financial expert.

This article was translated from the English by Leo Ginsberg. You can find the original here.

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