Factors affecting inflation
This article explores the main factors affecting inflation. Inflation is an important economic metric and a major factor in determining economic health. It is the rate of increase of the general price level of goods and services in an economy over a period of time. It affects all aspects of the economy, from prices of goods and services to wages and interest rates. While it can have some positive impacts on a country’s economy, it can also have negative effects. In this comprehensive guide, the readers will learn about the main factors that affect inflation and how to manage those factors to keep inflation under control. They will also gain insights into different types of inflation.
Definition of inflation
Inflation is the rate of increase in the general price level of goods and services in an economy over a period of time. It happens when there is a wide rise in the prices of products and services which means that consumers can purchase less for $1 today than they could yesterday. In other words, inflation decreases the value of the currency over time (European Central Bank, 2022).
Main types of inflation
There are three different types of inflation that economists often talk about. The discussion that follows focuses on them in detail.
Inflation caused by a rapid increase in demand for goods and services is called demand-pull inflation. Demand-pull inflation happens when there is an increase in aggregate demand, i.e. demand for goods and services in the economy, that outpaces the increase in the supply of goods and services. When demand for products and services increases, companies increase the prices for those items causing inflation. Some people still pay for plane tickets and hotel rooms for their holidays despite the prices being noticeably higher than normal. This is a good example of demand-pull inflation (Williams, 2022).
Inflation caused by an increase in the cost of production is called cost-push inflation. Cost-push inflation happens when there is an increase in the production costs of firms, leading to a rise in the prices of goods and services. This can happen if there is a decrease in the productivity of workers, an increase in the cost of raw materials, and/or an increase in minimum wages. When the production costs increase, companies are forced to increase their prices in order to operate sustainably and profitably. This leads to an increase in the price level, which results in cost-push inflation.
Inflation that is built into the economy is called built-in inflation. It is associated with the idea that people expect current inflation rates to continue in the future. For instance, when demand-pull inflation and cost-push inflation happen, workers/employees may start asking employers for a raise in their wages/salaries to maintain their standard of living. If employers do not address those demands, they may end up with a labour shortage. However, if they increase the wages/salaries and try to remain sustainable and make profits by increasing prices, then a built-in inflation occurs (Williams, 2022).
Factors affecting inflation
The main factors affecting inflation include changes in the money supply, expectations of inflation, and changes in productivity. The level of inflation in an economy is determined by the interaction of these factors.
Changes in the money supply
Inflation is caused by an increase in the money supply, which may be caused by an increase in the demand for money. When the money supply in an economy grows at a faster rate than the economy’s ability to keep pace with it in relations to the production of goods and services, inflation is very likely to occur.
Changes in the money supply affect inflation by influencing the demand for goods and services in the economy. When the money supply increases, the demand for goods and services also increases. This will increase the price level and result in inflation. When the money supply decreases, the demand for goods and services also decreases. This decreases the price level and result in deflation.
Expectations of inflation
The level of inflation that people expect in the future can affect the level of inflation that exists in the present. If people expect a higher rate of inflation in the future, they will start demanding higher prices for goods and services in the present. This results in an increase in the price level and inflation. On the other hand, if people expect a lower rate of inflation in the future, they will start demanding lower prices for goods and services in the present. This results in a decrease in the price level and deflation.
Changes in productivity
Productivity is important because it determines how much output an economy can produce from a given amount of input. Inflation is caused by an increase in production costs, which can happen if there is a decrease in productivity. When productivity decreases, firms must pay more to get the same amount of output. This results in an increase in production costs, and firms will have to pass these costs on to their customers by raising prices.
Effect of interest rates on inflation
Interest rates can affect both inflation and economic growth, although in different ways. When the interest rate is high, the demand for goods and services in the economy is low because people prefer to save their money rather than spend it. This results in a decrease in the price level and result in deflation. When the interest rate is low, the demand for goods and services in the economy is high because people prefer to borrow money to spend it rather than save it. This results in an increase in the price level and inflation.
Other factors affecting inflation
Other factors affecting inflation include changes in taxes and tariffs, changes in government spending, and changes in the exchange rate. When taxes are lowered, the after-tax incomes of households increase, which will increase the demand for goods and services. This will cause an increase in the price level and result in inflation. Similarly, when government spending increases, the demand for goods and services will also increase. This will cause an increase in the price level and result in inflation.
Effects of inflation on the economy
When inflation is high, it can affect an economy in different ways. For instance, when inflation is high, the purchasing power of money is reduced. People have less money to spend, and firms have less money to invest. This reduces demand for goods and services and results in lower employment.
Inflation reduces the standard of living. When everything is more costly, wallets are squeezed very badly. There is no doubt that it is impossible to survive without food and drinks. However, with increasing costs, it can become extremely difficult for many people to make ends meet. The older and lower wage earners are the first to feel the bite of inflation.
When inflation is high, debt will become more difficult to repay as time goes by. The Central banks apply different means to control inflation. And the most widely used option is increase in interest rates. When the interest rates go up, it gets more expensive to borrow money. Likewise, if people have any debt (loans, mortgages etc.) with a variable interest rate, their weekly/month payments will go up as well.
Summary of the factors affecting inflation
It is thus very clear that there are different factors that can affect inflation. While a limited inflation is good for an economy, it can cause severe turmoil if it goes up too fast and high. Therefore, the governments, central banks, and consumers have different roles to play to keep it under control.
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Last update: 09 December 2022
European Central Bank (2022) What is inflation, available at: https://www.ecb.europa.eu/ecb/educational/explainers/tell-me more/html/what_is_inflation.en.html (accessed 30 November 2022)
Williams, G. (2022) 3 types of inflation and how they differ, available at: https://www.forbes.com/advisor/personal-finance/types-of-inflation/ (accessed 25 November 2022)
Author: M Rahman
M Rahman writes extensively online and offline with an emphasis on business management, marketing, and tourism. He is a lecturer in Management and Marketing. He holds an MSc in Tourism & Hospitality from the University of Sunderland. Also, graduated from Leeds Metropolitan University with a BA in Business & Management Studies and completed a DTLLS (Diploma in Teaching in the Life-Long Learning Sector) from London South Bank University.