What Causes Inflation? Everything You Need To Know.
Noticing higher prices? Here's everything you need to know about inflation, including what causes it and where it can hit the hardest.
In the last two years, inflation has been a word on everyone's minds. It seems unavoidable, whether you're at the gas pump, the grocery store, or really anywhere else.
So why is this happening? And what causes it? Keep reading for all you need to know about inflation.
What is inflation?
Inflation measures the rise in PCE (personal consumption expenditures price index) or the expenses of goods and services over a certain period.
Generally, inflation rates are measured by year and examined on a broad scale of a country's overall goods and services. However, inflation can also be measured using shorter or longer periods and can focus on one particular industry or product.
Related: What New Entrepreneurs Should Know Amid Rising Inflation
How is inflation measured?
The measure of inflation follows a formula called the consumer price index. The consumer price index assesses the cost of living and how it changes over time.
The CPI formula takes the value of the market basket from a particular year, divides it by the value of the market basket from the base year, and multiplies that by 100 to produce a percentage.
- Consumer Price Index = Value of Market Basket in Particular Year / Value of Market Basket in Base Year x 100
Once the CPI is calculated, the Inflation Rate Formula comes in. The Inflation Rate Formula involves two key variables.
- A = CPI starting cost
- B = CPI ending cost
Keeping those two variables in mind, the Inflation Rate Formula is as such:
- ((B - A) / A) x 100
To carry out this formula, begin by subtracting A from B to determine the price change for the good or service. Next, divide that result by A to achieve a decimal number. Multiply that decimal number by 100 to produce a percentage. That percentage change is the result and the rate of inflation.
Types and causes of inflation
Inflation is not always caused by just one thing. Several economic factors dictate inflation rates. Because of this, there are different types of inflation.
Demand-pull inflation occurs when an economy's aggregate demand exceeds the aggregate supply. Demand-pull inflation comes into play when there is a higher demand than there is supply.
While inflation is not something people generally look forward to, it can be a sign of a healthy economy. Aggregate demand indicates high employment rates and higher levels of disposable income.
When workers have more disposable income, luxury and necessary spending rates increase, driving demand.
There are a few leading causes that trigger demand-pull inflation:
- Household spending: When consumers feel comfortable enough to make discretionary purchases, it throws off the consumer price index because it is a new factor in the economic ecosystem. The general rule is that when consumer demand increases suddenly, the cost will follow the same pattern.
- Business spending: Business spending is dictated by an economy's gross domestic product (GDP). When the economy is healthy due to consumer spending, businesses increase production to keep up with that spending. The aggregate demand of consumers creates price increases for goods and services.
- Government spending: During a recession, a government's central bank will often try to kickstart the economy by dedicating monetary policy funding to new infrastructures and programs to create more jobs. While this is meant to help an economy, it also brings new market capital and drives prices up.
- Foreign investment: Foreign investment is most prevalent when one country's exchange rate is more favorable for buyers in another country. This means that if a large portion of buyers from one country finds affordable properties in another country, that will cause demand-pull inflation in that country's market.
Related: Inflation Is a Different Beast for Entrepreneurs. Here's How to Protect Yourself
Cost-push inflation happens when an aggregate supply of goods and services experiences a decrease. An increase in raw materials generally causes this decrease in production cost or the labor it takes to produce those goods and services.
There are a few leading causes that trigger cost-push inflation:
- Labor market: Salaries, healthcare and other benefits qualify as labor expenses. When unions negotiate wage increases or a government mandates new benefit requirements from employers, those new expenses can trigger cost-push inflation.
- Capital: Capital is essential for any business, and it is common for companies to borrow money supply. However, the problem arises when investors limit their funding, or a business must pay an increased interest rate because those factors cause that business to increase the price of its products.
- Land expenses: Environmental events like natural disasters can affect inflation and the cost of rent and construction for a business.
- Entrepreneurship: When a new business begins or an existing business decides to scale, many costs are involved. Company costs like raw goods, rising wages and workspace all cause an increase in product prices, which can result in inflation.
Built-in inflation is the natural inflation that happens over time. As the prices for goods and services rise, people expect higher wages with those prices to afford rising costs of living.
Related: How To Negotiate Renewed Contracts During Periods of Inflation
Inflation throughout history
The Covid-19 pandemic threw the economy for a loop, and now the world's economy is experiencing aftereffects in many areas, especially inflation.
As the supply chain of major industries like retail, real estate, auto and travel race to catch up to the increased demand, prices are being driven up.
This is not the first time in history that inflation hikes. To prepare for what might lie ahead, look at inflation trends throughout U.S. history.
Related: How Does Inflation Affect Real Estate? Here's What You Need to Know
July 1946 - October 1948
During World War II, the job market shifted, and people were conservative with their spending. However, once the war ended, the economy experienced a boom that it was not prepared for.
Demand was more significant than supply as people became liberal with purchases they had not been able to make during war times. Because of this rapid shift, inflation rose to over 20 percent.
December 1950 - December 1951
As the Korean War began in June 1950, people were accustomed to wartime mandates. Families raced to purchase necessities to prepare for rations and supply shortages, significantly increasing demand.
Once the war ended, people seemed to have learned from the late forties situation and did not rush to buy post-war like they did the first time. Because of this more reserved behavior, prices rose but not nearly as much as they had a few years prior.
March 1969 - January 1971
The economy and job market were booming during this period, increasing prices. Because inflation was so drastic, the government stepped in and mandated a wage and price freeze.
April 1973 - October 1982
The seventies brought the U.S. the most prolonged period of inflation to date. An oil embargo followed by a decline in oil production during the Iran-Iraq War caused lasting inflation rates.
Again, the Federal Reserve (sometimes referred to as "The Fed") had to step in. That meant increased interest rates to level out the inflation rate.
April 1989 - May 1991
The first Gulf War brought much uncertainty in the supply chain and relations. This trepidation drove up crude oil prices, leading to a short inflation period.
July 2008 - August 2008
While this was a short-term period, it took a considerable toll on the economy. Exponential rises in gas prices shot the CPI up five percent over these two months. The cost of crude oil doubled in only a year from $70 to $140.
Pros and cons of inflation
Inflation means rising prices, so how could there be positives to that? Like anything else, there are pros and cons to inflation.
Pros of inflation
- Enhanced economic growth: During inflation periods, businesses often experience higher demand, which causes them to increase production to keep up. To keep up with increased production, companies must hire more workers or provide current workers with more hours, leading to a healthier job market.
- Provides for wage adjustment: Inflation creates a type of "new normal," which allows companies to adjust the prices of goods and services and employee wages.
- Better borrowing: Many people are given wage increases due to inflation. However, loan interest rates that were established before inflation do not increase. This means that employees who receive raises have more financial capital and might be able to pay off their loans faster or at least with less pressure.
- Increased employment rates: Because goods and services become more expensive, businesses have more revenue to put back into their company with more jobs and production.
Cons of inflation
- Impacted savings: As goods and services become more expensive, a gap can often occur as the rest of the economy levels out. If living costs rise but wages do not, it becomes increasingly difficult for people to save.
- Decreased investments: When there is uncertainty in an economy, investors become more tentative with their money. Investors also want their money to go as far as possible, and inflation slows that process.
- Less competition: The economy needs competition. However, with countries that use the same currency, it can be challenging to evaluate currency value if one experiences inflation but the other does not. This slows the import and export system and ultimately slows the economy.
- Disadvantages for pensions and minimum wage: During periods of inflation, the minimum wage is generally the last to experience a raise. Because the government controls the minimum wage, it is up to them to raise it rather than the employer. In addition, those who receive pensions on a fixed rate will receive the same amount of money even though inflation will affect how far the dollar goes.
Related: This Is the Living Wage You Need in All 50 States
Where inflation hits the hardest
While no city has remained immune to inflation, some areas have been hit much harder than others.
Some of these cities were becoming more affordable before the pandemic. However, the economy experienced such a shift during the pandemic years that most have experienced a yoyo effect.
And it's not only expensive cities that have continued to become more expensive; rather, some formerly affordable cities have experienced the most change. Take a look at the 15 cities that have experienced the highest rate of inflation based on the CPI change in the last year.
1. Anchorage, Alaska
- Score: 100.00
- CPI change: 12.40%
2. Phoenix - Mesa - Scottsdale, Arizona
- Score: 68.38
- CPI change: 12.30%
3. Atlanta - Sandy Springs - Roswell, Georgia
- Score: 56.22
- CPI change: 11.50%
4. Seattle - Tacoma - Bellevue, Washington
- Score: 50.51
- CPI change: 10.10%
5. Baltimore - Columbia - Towson, Maryland
- Score: 50.13
- CPI change: 10.60%
6. Miami - Fort Lauderdale - West Palm Beach, Florida
- Score: 49.36
- CPI change: 10.60%
7. Houston - The Woodlands - Sugar Land, Texas
- Score: 48.28
- CPI change: 10.20%
8. Detroit - Warren - Dearborn, Michigan
- Score: 45.58
- CPI change: 9.70%
9. Tampa - St. Petersburg - Clearwater, Florida
- Score: 45.22
- CPI change: 11.20%
10. Philadelphia, Pennsylvania - Camden, New Jersey - Wilmington, Delaware
- Score: 32.57
- CPI change: 8.80%
11. St. Louis, Missouri
- Score: 29.95
- CPI change: 8.40%
12. Dallas - Fort Worth - Arlington, Texas
- Score: 27.65
- CPI change: 9.40%
13. Riverside - San Bernardino - Ontario, California
- Score: 26.73
- CPI change: 9.20%
14. Chicago - Naperville - Elgin, Illinois
- Score: 26.42
- CPI change: 8.80%
15. Denver - Aurora - Lakewood, Colorado
- Score: 22.87
- CPI change: 8.20%
Inflation expectations: How much longer will it last?
As history shows, inflation is an expected result after a considerable economic disruption. The pandemic was certainly a significant disruption, and the world's economy is still experiencing aftereffects.
In addition to the pandemic, other world events have had additional effects on the world's economy. So, how much longer will inflation last?
The economy has been relatively unpredictable in the wake of these events, and economists continue to gather and study data to offer predictions on what people can expect.
The World Economic Forum's data shows that in 2021, global growth was forecast at six percent, and it slowed to about three percent in 2022. Global growth is expected to slow even more in 2023 at just under three percent. As for inflation, deflation may be coming.
Rates are expected to decline from just under nine percent in 2022 to six and a half percent in 2023 and four percent in 2024.
However, economists also take history into account. While inflation rates are predicted to decline, a key caveat in the equation is the eight percent threshold.
History indicates if inflation exceeds eight percent, which it did in September 2022, high inflation can take much longer to decline.
What you can do to prepare for inflation
With no clear answer about when inflation will recede, it can't hurt to put a few precautions in place. Take a look below for four strategies experts recommend to help you prepare for higher inflation.
1. Budget accordingly.
You don't have to change your whole lifestyle, but if there are little things you can cut out to save extra cash, now is the time.
Whether combating food prices by cooking at home one extra night a week or pausing a subscription you don't use that much, focus on the essentials for the time being.
2. Create and maintain an emergency fund.
Now is a great time to start if you don't already have an emergency fund. Those small luxuries you just cut out? Input them into the fund and save them for a rainy day in preparation for hyperinflation.
Related: 6 Best Savings Accounts Of 2022
If you're savvy with the stock market or have always wanted to get involved, study and find a suitable investment. If you don't think that's the right fit, take that emergency fund and convert it into something like a high-yield savings account that will build better interest over time.
Related: 6 Best Investments For Inflation
4. Keep a close eye on debt.
From student loans to personal finance, sometimes debt can be unavoidable. However, the key is not to get in too deep.
If you have to take on debt, make sure that you have a payback plan and that you are not committing to high-interest debt that will be more difficult to pay off in the long run.
Related: 3 Strategies To Protect Your Business From Inflation
What does inflation mean for you?
Several factors cause inflation; unfortunately, those factors currently affect the entire world.
While some hope inflation will recede in the coming year or two, other elements might slow that process. In either case, it is always prudent to prepare some backup funds if you ever need them.
Explore the rest of Entrepreneur.com if you're looking for more information on professional-impacting topics like the economy, unemployment rates or investing.