Causes of Inflation, Effects of Inflation (and Why they Both Matter)

inflationLike most people, all you probably know about inflation is that it makes things more expensive. However, there are a broad array of inflationary effects that can cause headaches for consumers, investors and businesses alike. Learning the causes and effects of inflation will help you know when inflation might be coming and will help you prepare for an inflationary period and protect your investments.

Definition of Inflation

  • Inflation refers to increases in the cost of goods and services over a time period in either a national or international economy. It is usually expressed as a yearly percentage.
  • Negative inflation is called deflation and results in lower prices.
  • Core inflation is an inflation metric that excludes certain volatile markets like energy and food.
  • Hyperinflation is a term used for very high rates of inflation that have spiraled out of control.

Current Inflation Rate

The inflation rate for June 2011 stood at 3.56 percent. This is in contrast to the 2010 inflation rate average of 1.64 percent. While slightly high, this is well in keeping with the tolerances of the inflation index generally.

Causes of Inflation

Inflation is the result of a number of complex economic factors with no clear consensus among economists. Some proposed factors for causes of inflation include:

Increase in overall monetary supply. When the total amount of money available increases, the value of that money decreases.

Increased labor costs. Greater labor costs drive up the cost of prices as labor is one of the most significant factors in overhead.

Demand pull. This refers to a situation when prices of goods and services increase because there are not enough goods and services to meet market demand.

Cost push. Cost-push inflation occurs when a vital product has its supply line interrupted or costs dramatically increased. A rise in petroleum prices leading to increased costs in the general economy is a perfect example of cost-push inflation.

Negative Effects of Inflation

Inflation has a number of effects. These are worthy of note to businesses, investors and everyday consumers:

  • Unemployment: When the cost of goods and services go up, companies have higher overhead costs and consumers purchase less. This can lead to a downturn in the economy where jobs are the first casualty.
  • Investment Bubbles: When inflation is kept artificially low it can lead to speculative lending and borrowing. This has a tendency to increase bad investments overall–a tendency that will eventually be corrected by the market.
  • Hoarding: Particularly during periods of hyperinflation, people have a tendency to hoard goods. This is because the goods might cost more tomorrow than they did today.
  • Social Unrest: One of the most far-reaching effects of inflation is general social unrest. Food inflation was identified as one of the primary causes behind the Arab Spring revolts.

Positive Effects of Inflation

Inflation isn’t without its positive effects. Even hyperinflation can have beneficial effects:

  • Debt: High inflation tends to wipe out debt. Once the current inflation rate exceeds the interest rate on a loan or other debt, inflation is literally eating it away.
  • Mundell-Tobin effect: This is a complex effect related to inflation. Moderate inflation has a tendency to cause firms holding onto money to start lending. This glut of lending capital causes interest rates to fall. This in turn makes it easier for firms to get loans for further investment and economic growth.
  • Offsetting negative effects of deflation: Deflation might sound good on the surface–an increased value of your money. In reality, however, deflation often leads to short, sharp jags of hyperinflation.

The Inflation Index and You

The causes and effects of inflation are  as inevitable as death and taxes. However, much like death and taxes, there are ways to deal with inflation to mitigate the damages.

Hard Investments

Invest in material goods rather than more abstract investments such as stocks. Gold investments generally hold value against inflation, for example. Buying durable goods you know you’ll use are another way to combat core inflation.

Bartering

Examine your skill set. See what services you can trade for goods. For example, you might be able to fix your neighbor’s computer in exchange for him mowing your lawn.

Avoiding Certain Loans

Long-term, fixed-rate loans such as bonds are not good investments during an inflationary period. This is because the rate of inflation can easily wipe out any profits from the interest rate.

Thinking Long-Term

Long-term capital investments are the best way to combat the effects of inflation. These investments mitigate the amount of your investment that will be wiped out by the effects of a short-term increase in the inflation index.

Understanding how to avoid the negative consequences of inflation is arguably more important than understanding how inflation works, though a working knowledge of the effects on businesses, investors and consumers will help you to insulate your own investments. You might even be able to turn hyperinflation to your own advantage if you play your cards right.

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  • PavolBajusz

    Thank for your article, providing a balanced view on inflation.

    People see it usually from negative side. .Best wishes

    Paul

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