Inflation refers to the increase in the prices of goods and services in the economy. This causes a unit of currency to effectively be worth less than it was at a lower inflation rate.
The rate of inflation is represented as a percentage, which reflects the overall impact of the increases in prices in an economy .
Conversely, deflation occurs when prices decline and purchasing power increases.
What Causes Inflation to Happen?
Inflation causes prices throughout an economy to rise, causing each unit of currency to be worth less. As a result, the same amount of money buys fewer goods and services, reducing the purchasing power of consumers. But what causes this to happen?
Inflation most commonly occurs when there has been an increase in the supply of money. Inflation may result from loaning new money into existence by purchasing government bonds from banks on a secondary market, legally devaluing the legal currency. Similarly, it may be because more money is printed and distributed whilst demand amongst consumers rises.
However, the main causes of inflation can generally be divided into three categories: built-in inflation, demand-pull inflation, and cost-push inflation.
Types of Inflation Explained
Built-in inflation, demand-pull inflation, and cost-push inflation are the three broad categories that inflation falls into:
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Built-In Inflation: People’s expectations that the current inflation rate will continue on the same path in the future cause built-in inflation. This expectation prompts workers to demand more wages to maintain their current standard of living as they expect inflation to continue. Consequently, an increase in wages means an increase in costs for goods and services.
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Demand-Pull Inflation: This happens when the supply of money increases. As a result, the demand for goods and services rapidly increases more than an economy can provide. When people have more money, they spend more. Hence, a demand-supply gap occurs where there is higher demand and less flexible supply.
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Cost-Push Inflation: This occurs when overall prices increase because it costs more to produce goods and obtain raw materials. Therefore, businesses are faced with higher prices for input and, therefore, are influenced to increase the price of output.
What Are the Advantages of Inflation?
Although inflation may seem like a real drag on an economy, it can actually offer some real benefits to lending terms when it comes to financial products like payday loans and others:
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Sell Assets for More: When there is inflation, individuals with tangible assets may see a rise in the prices of their assets. If the price of their assets increases significantly, they can sell them at a higher rate.
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Encourages Investment: Inflation can also encourage businesses and individuals to invest in company stocks, as they expect to receive better returns due to the rise in stock value.
What Are the Disadvantages of Inflation?
The big problem with inflation is that it can cause unease on a much larger scale.
- Inflation leads to uncertainty in the wider economy, as it can be difficult to adjust to needing to pay more for goods and services.
- Although individuals with assets may sell them at a higher rate if inflation occurs, inflation can also cause dissatisfaction to those who hold assets. Whilst their value can go up, inflation can also erode the value of their holdings.
- Furthermore, when new money and credit enter the economy, it is always in the hands of specific individuals or business firms. This causes inflation to drive up some prices first and others later, causing not only a rise in general prices but also a distortion of relative prices and wages.
So, in conclusion, whilst too little inflation is considered harmful, too much is generally considered just as bad for an economy. Many economists advocate for a middle-ground of low to moderate inflation to nurture a growing and stable economy of around 2% per year.
