Financial Friday: Inflation

What Is Inflation?

Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

KEY TAKEAWAYS

• Inflation is the rate at which the value of a currency is falling and, consequently, the general level of prices for goods and services is rising.
• Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
• The most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

Causes of Inflation

In all such cases of money supply increase, the money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Inflation

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises. With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.

Cost-Push Inflation

Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into a commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodities, costs for all kinds of intermediate goods rise. These developments lead to higher costs for the finished product or service and work their way into rising consumer prices. For instance, when the expansion of the money supply creates a speculative boom in oil prices the cost of energy of all sorts of uses can rise and contribute to rising consumer prices, which is reflected in various measures of inflation.

Built-in Inflation

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs or wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

Inflation impacts our cost-of-living and causes us to make changes to our spending and budgeting. Long Term inflation assumptions are needed in an effort to create Financial Plans.

A Financial Element, similar to a literary element, refers to components of a Financial Narrative. Understanding the financial elements can help us in creating and planning Your Financial Narrative. We will continue to look at various other financial elements each week as a part of the Financial Fridays