Inflation measures the rate at which prices of goods and services rises and falls in an economy. There are many different causes of inflation including a surge in demand and increased production costs. When inflation becomes too high, there are certain actions that policymakers can take to curb inflationary pressures and bring the rates back down.
How does inflation work?
Inflation is dependent on the continually fluctuating needs of consumers. Depending on their needs, demands for products and services will change and consumers may be willing to pay more or less for a certain good. Inflation measures the increase in the price level of goods and services in an economy.
When prices rise, it means that a unit of money buys fewer goods and services than it previously did. In other words, you are paying more for the same thing. This leads to a deceleration in economic growth as spending decreases. If this occurs, the central bank has to take action to manage money supply and control inflationary pressures.
What causes inflation?
There are various causes for inflation. Typically, inflation will occur following an increase in demand for products and service or increase in production costs.
This is when there is a decrease in the aggregate supply of goods and services due to an increase in the cost of production. This could be an increase in the price of raw materials or increased wages for labour costs. Because the demand remains unchanged, but the supply has decreased, consumers incur the added costs.
In addition to increased costs of raw materials or higher wages, natural disasters can also lead to cost-pull inflation. If a natural disaster wipes out a certain crop, it will impact the cost of that crop and any product that uses it.
This type of inflation occurs when there is a strong consumer demand for a good or service. When unemployment is low and wages are rising, consumer confidence tends to be higher, resulting in more spending. While more spending leads to economic growth, it can also directly impact the cost of products and services, making things more expensive.
As demand increases, supply subsequently will decrease. This makes items more scarce meaning that consumers are willing to pay more for the item.
Companies also impact inflation as they can choose to raise the price of their goods or services if they sense that consumers are willing to pay more. This applies to everything from online loans Texas to car sellers and even retailers. They have even more power if what they are selling is something essential for everyday use such as gas or oil.
Why does inflation rise and fall?
Periods of high inflation are not sustainable in the long run. If the money supply outgrows an economy, the value of a unit of currency will decrease meaning that purchasing power falls and prices increase.
Consumer expectations can also influence inflation. For example, if individuals or companies anticipate higher prices, they may change their spending behaviours. In some cases, expectations can become self-fulfilling.
When there are pressures on the supply or demand of a goods or services, impacting the economy, it can cause a ‘supply shock’ or ‘demand shock’. When this happens, central banks need to act in order to control these inflationary pressures and prevent recession. It is the responsibility of policy makers to strike a balance between boosting demand and growth when necessary without causing inflation by oversitmulating the economy.
Disinflationary policies, the measures that policymakers take to reduce inflation, will depend on the cause of the inflation.