Have you ever wondered why your monthly grocery bill keeps increasing over time? Have you ever noticed your fixed income is bringing you less and less goods? Or do you ever get curious about the cost of living of your parents or previous generation? If yes, then you need to know about inflation and its effect on your lifestyle in particular and its impact on economy in general.

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” – Sam Ewing (1920-2001), American writer and humorist

Bureau of Labor Statistics defines inflation as the overall general upward price movement of goods and services in an economy. In other words inflation means increase in the general level of price of goods and services over a period of time. It cannot be measured by an increase in the price of one good or one service; rather it is the sustained rise in the price of all goods and services. It is expressed in annual percentage.

The value of money is expressed in terms of its purchasing power i.e., the real goods and services which you can buy with that money. As inflation rises, dollar cannot stay constant and every dollar you own brings you lesser and lesser goods and services and thus loses its purchasing power. For example, a bar of chocolate which costs you $1 will cost you $1.03 next year if the rate of inflation is 3%. Inflation is an important issue in any economy and it affects every individual in one or the other way. It affects not only the larger issues such as retirement income & state pension/benefit plans but also the smaller issues like the price of a movie ticket.

Causes of inflation

There are several theories regarding what exactly causes inflation. But two of them, which is universally agreed by the economists, are as follows:

Demand pull inflation

If demand for goods and services grows faster than supply then the prices will increase. When people have more money in their hands, their demand for goods and supply increase; when more and more people demand for goods, seller faces the problem of shortage of supply which forces him to sell the goods for an increased price. This can be described by the often used phrase ‘too much money chasing too few goods’. So the basic factor behind the inflation is the increase in the supply of money. This is the usual phenomenon in a growing economy.

Causes of demand pull inflation include:

• Growing economy: When people feel secure about their job and expect better pay they tend to spend more instead of saving. The increase in demand for the goods and services rises price gradually. When the economy is growing, people more readily take auto loans and mortgage loans which also contribute to the rising demand. When the borrowing is within a limit, it contributes to the steady inflation and thereby to the growth of economy.
• Government policy: The government fiscal policy also contributes to the inflation. When the government reduces taxes, people are left with more discretionary income to spend. For example, tax benefits on interest on mortgage loans increases demand for housing. Increase in demand will result in inflation if the demand is more than supply.
• Inflation expectation: Expectation about inflation itself causes inflation – though it sounds funny, it is true. Ben Bernanke, the chairman of The Federal reserve pointed out this and said that once people expect inflation then they start buying now before prices increase further. This increase in demand will create demand pull inflation. Once this expectation sets in, its very difficult to extinguish it.

In short, demand pull inflation is a result of increase in demand that is faster than increase in supply.

Cost push inflation

Here inflation is the result of decrease in the supply of goods and services. This is the situation where the general price level rises (inflates) due to rise in the wages and cost of raw materials. When the cost of production increases, the manufacturers/ producers cannot produce the goods at the same cost. So to maintain their level of profit margin, they pass this cost onto the consumers by increasing the cost of their product. So even if the demand for goods remained constant, the prices go up and cause inflation.

Reasons for the increase in cost of production which causes cost push inflation are as follows:

• Monopoly: Cost push inflation may be created by the manufacturers/producers who have achieved monopoly over the industry. Because of their exclusive position they are able to charge higher prices for their goods and services.
• Increase in wages: Increase in wages shoots up the cost of production which the manufacturers readily pass on to the consumers and results in increase in prices. To give an example, once the labor union of US auto industry successfully pushed the companies for higher wages.
• Natural disasters: Natural disasters like earthquake, hurricane may disturb the process of production and because of this cost of raw materials may also increase which compels the manufacturers to increase the price. Thus, natural disasters become another stimulant for cost push inflation.
• Government policy: Government policy regarding tax and tariffs also contribute to the cost push inflation.
• Exchange rate: Another cause for cost push inflation which is bit difficult to explain is exchange rate. If the value of the foreign currency, in which goods are traded / imported, increases compared to the U.S dollar then the prices of such products will increase.

Thus, anything that causes decrease in supply of goods and increase in cost will lead to cost push inflation.

How is inflation measured?

Measuring inflation is a complex process performed by Government statisticians. For this, various goods and services used by general population are taken together (which is called ‘market basket’) and then the cost of this basket is compared over time. The relative change in the prices of this market basket over time, which is expressed in percentages, is called price index.

The two main price indexes that measures inflation are:

Consumer Price Index (CPI)

The CPI in the United States is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” In short, Consumer Price Index measures the changes in the price level of goods and services purchased/used by typical urban households.

Every month, US Bureau of Labour Statistics contacts retail stores, service establishments, rental units and doctors’ offices and get the information about the prices of thousands of items and track the changes in CPI. They record the prices of about 80,000 items specifically selected and used by consumers. It is based on the expenditures of all urban population such as professionals, self employed, retired people as well as wage earners and clerical workers. Together they form 87% of total US population. The CPI affects all Americans and it is used as an economic indicator.

Producer Price Index (PPI)

The Bureau of Labor Statistics defines Producer Price Index as “a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services.” Thus, PPI measures the average change over time in the prices received by producers. In other words, it measures the change in price from producer’s point of view. There may be a difference between the price received by the producers and selling price because of various taxes and distribution costs.

PPI is widely used by government and private business entities as an indicator of CPI, as they foretell the changes in price before the retail level.

Impact of inflation

• People who live on fixed income feel the pinch. Whatever the annual cash flow they have, brings them lesser goods and services because of decrease in purchasing power of money. It means, inflation affects their standard of living.
• If inflation is too high (comparatively with other countries) then the domestic produce becomes less competitive.
• Inflation discourages the entrepreneurs and general consumers from spending which affects economy in the long run.
• Creditors lose because the money repaid to them has become less valuable.
• Debtors gain because of inflation whatever the money they repay along with interest is of less value. In a way, it is just like they got loan with lesser interest.

The Fed and Inflation Control

The objective of Federal Reserve, as spelled out in Federal Reserve Act, is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Stable prices ensure efficient allocation of resources and thus result in better standard of living. Further, stable price encourages savings and capital formation; because when there is no fear of erosion of values of assets from inflation the individuals get encouraged to save more and the producers are encouraged to invest more.

The Fed closely watches CPI and PPI and accordingly varies its Federal funds rate from time to time. Any change in the Federal funds rate will in turn influence the mortgage lending rate and thus finally determines money supply in the economy. The primary mission of the Fed is to control inflation and at the same time to maintain a healthy economic growth.

Bottom line

While talking about economy and general standard of living, people often complain about increasing prices and show their fingers at inflation; but they ignore that wages also rise along with rise in prices. Inflation does not hurt if it does not rise faster than your wages and rate of return on your investments. So it may not be correct to tag inflation as good or bad; it depends on the economy in general and personal financial situation in particular. Low and steady inflation (around 2%) is a sign of growing economy which is very much acceptable for the financial wellness of the country.