What Really Causes Inflation Made Easy to Understand
As prices go up over time, the amount you can buy with a set amount of money slowly goes down. But different things can cause inflation to go up or down depending on the state of the economy.
I will keep this short and simple because otherwise, you will not be here for long. Although we should not simplify complex social sciences like economics, to understand what inflation is, what causes it and why we are experiencing it, we must make these concepts more accessible to everyone.
What is Inflation?
Too much money is being spent on too few goods and services. The price of goods and services going up over time is called inflation. Because of inflation, you will be able to buy fewer things with the same amount of money in the future as you can today.
Inflation is a lagging indicator that provides information on something that has already happened and is used to confirm information instead of forecasting.
We start with a "market basket" of goods and services to calculate inflation. The price level of this "market basket" is measured monthly. This basket includes some of the products and services that urban households usually use, but not all. The consumer price index is made from this market basket's current value, which is calculated by adding the cost of every item in the basket.
The next step is to compare how much a market basket of items costs now to the past. Then, inflation is worked out by comparing the prices of the market basket of goods during the base period to the cost of the market basket of goods during the most recent period. For instance: If the Current Price Index is 255 in March 2021 and rises to 260 in March 2022, inflation would be 1.9% over those 12 months.
What are the causes of inflation?
Many factors can lead to inflation, but demand-pull and cost-push inflation are two of the most common. However, inflation in 2022 is caused by a bit more than that. They are partly the result of the government's response to the pandemic and sudden increases in demand after the coronavirus lockdown restrictions were lifted and labour shortages across all sectors.
Here are the main reasons why prices go up:
When more people want certain goods and services than the economy can supply, this is called demand-pull inflation. When this demand exceeds the supply, prices go up, causing inflation.
A practical example would be tickets to see Adele live in her preferred venue, the theatre. Because there were a limited number of seats and the demand for the show was far greater than capacity, the price of tickets skyrocketed on third-party sites, well above the standard ticket price.
Cost-push inflation is the increase of prices when the cost of wages and materials goes up. These costs are often passed down to consumers through higher prices for those goods and services. An example of this would be lumber, an input suitable for houses. When the cost of timber spiked as much as 400% in 2021, it impacted the increase in housing prices resulting in inflation.
Increased money supply
The increased money supply is the total amount of money in circulation. This includes cash, coins, balances, and bank accounts. Let's say that the amount of money grows faster than the production rate. If that happens, it could lead to demand-pull inflation because too much money will be spent on too few goods.
When a country's exchange rate goes down, causing the value of its currency to go down, this is called "devaluation."
When a country's currency loses value, its exports become cheaper, which makes other countries more likely to buy those goods. When a country devalues its currency, it must pay more for foreign goods. This means that people in the country whose currency is losing value can buy goods made in their own country instead of from other countries.
Raising wages means just what it sounds like: putting more money in workers' hands. "Wages are a cost of production." If wages go up a lot, businesses will have to either pass the cost on to customers or live with lower profit margins. The only time this isn't true is if they can make up for rising wages with higher productivity.
But economists are still divided about the effects of slow wage increases, like raising the minimum wage, compared to faster, more rapid wage growth in places like banking. Some think that if wages go up, businesses will have to pay more, leading to cost-push inflation. Others, on the other hand, believe that higher wages everywhere, not just in specific industries, will increase demand enough to make up for a price rise.
Policies and regulations
Cost-push or demand-pull inflation can also happen when specific policies are implemented. When the government gives tax breaks to certain products, it can make more people want those products. If there is more demand than supply, prices could go up. Also, strict building rules and even rent stabilisation policies could increase costs and cause inflation by passing those costs on to residents or artificially reducing the number of homes available.
The usual rate of inflation is around 2 per cent. A higher inflation rate like the current one means that our cost of living is already 10/12 per cent higher than 14 months ago. The current prices will not go down in the next 12 or 24 months. Even though we bring inflation under control, in a year, our basket of items will increase by at least 2 per cent. So, without an increase in wages, people will remain worse off and poorer in the medium and long run. But, how is it possible that we are poorer if we have seen that inflation is partially driven by lots of cash in the economy? Good question! The answer is that all this wealth is badly distributed: if we look at the UK population, half of the people have only enough to live, a significant number live under the poverty line and very few own most of the country's wealth.
We are going through a long period of instability. The good news is that ultimately it will bring a change. But a change will come once we reach the very bottom. And we are not there yet.