In the field of economics, no single concept causes as much consternation as does that of inflation.
As used herein, the term inflation is defined as a persistent, substantial increase in the general level of prices related to an increase in the volume of money; and ultimately resulting in the loss of the value of the subject currency.
Simply put, inflation refers to an economic situation in which prices rise while, at the same time, the value of the economy’s currency falls.
Here are some common factors that influence inflation:
Most people understand the fundamental connection between supply and demand. Typically, as supply goes up, demand tends to go down. Alternatively, as supply goes down, demand tends to go up.
However, most people often fail to appreciate that the value of money is actually determined by perception.
For example, when people in a society feel optimistic about their collective economic future, they tend to spend more. Similarly, when people in a society feel pessimistic about their collective economic future, they tend to spend less.
When there is more money in circulation prices tend to rise. When there is less currency in circulation, prices tend to fall.
Rising national debt can drive inflation higher.
This typically leaves legislators with two available options: (1) raising taxes; or (2) increasing the money supply.
A higher tax rate will generally force higher prices to offset a tax increase. Increasing the nation’s money supply will affect the perception of its value; and may cause currency devaluation.
A growing economy – typically marked by low rates of unemployment – can lead to increased consumer consumption and buying power. This can also result in higher demand.
Companies will therefore raise prices to a level that consumers will find reasonable, thus balancing supply and demand.
Cost-Push effect is an economic theory premised upon the notion that increased input costs need to be passed on to the consumer as a way to preserve profits.
Companies pass on the increase in goods and production costs to consumers by hiking prices, thus contributing to inflation.
In today’s complex global economy, the nation’s exchange rate plays a much more significant role in determining inflation rates than it did even a generation ago.
With increasing exposure to international trade partners, the U.S. dollar has become less relevant.
This has resulted in cheaper goods shipped from foreign markets, which in turn results in higher prices locally.
Inflation’s effects on an economy can be both positive and negative.
The negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation (which may discourage investment and/or savings), and if inflation is quick enough, shortages of goods. The positive effects of inflation include ensuring that central banks can adjust real interest rates (thereby helping to mitigate the potential of a recession/depression), and encouraging infrastructure investments.