What is Inflation and What Causes It?

What is Inflation and What Causes It?

By Chris Whitaker, CFP®

The year is 1948. Your friend Roger, who is wearing a plaid sport shirt tucked in near his belly button, excitedly tells you that the BBQ place on West 14th Street has now re-opened as a burger place called “McDonalds.” You park your Chevy Fleetmaster, and walk up to a small service window and order the cheeseburger for 19 cents.

If you and Roger – more likely to be named “Liam” now – had that same experience in 2018, Roger would be wearing an untucked T-shirt and pulling Google Maps up on his smartphone to find the closest McDonalds out of all ten near you. Both of you would roll through the drive-thru in your Tesla and see a greatly expanded menu. If you picked the equivalent cheeseburger, it would cost $1.69.

Of the many differences the change in price has the most impact. Simply stated, inflation is the trend that things get more expensive over time. As prices continue to rise, the purchasing power of a dollar decreases. Different goods and services are subject to inflation at varying rates but generally speaking one 1950 dollar holds the same buying power as $10.23 2018 dollars.

Inflation can be a complicated topic, so let’s break it down and explore the basic causes of simple inflation.

The Root Causes of Inflation

At its root, inflation is the result of the functions of supply and demand influencing one another to drive price levels up. There are two commonly accepted causes of inflation: cost-push and demand-pull inflation. When production input costs rise, producers shift that increase onto consumers resulting in higher prices for final products. This is cost-push inflation. Conversely, when demand for a product increases such that supply cannot keep up, enterprising business entities increase prices to capitalize on the desire of the consumers.

These basic definitions are easy enough to understand but as with most economic concepts examples can help drive home the ideas. Let’s dive into a hypothetical business to see how this plays out.

The Curious Case of Little Johnny

We’ll use “Little Johnny’s Lemonade Stand” as our business. It costs Little Johnny 15 cents to produce one glass of lemonade that he turns around and sells for 50 cents. Then, the cost of sugar increased and Little Johnny offsets his increase production costs by increasing his price to 55 cents per cup of lemonade so he can continue funding his extravagant baseball card-collecting habit. Little Johnny just demonstrated cost-push inflation.

Now, Little Johnny’s lemonade is so delicious that his neighbors continue buying regardless of the price increase. You could say they demand it. Our young entrepreneur has his eye on an autographed Clayton Kershaw rookie card and realizes that he holds some serious pricing power at his fingertips. Little Johnny capitalizes on the high demand for his product by increasing his price to $1.00 per cup of lemonade and his lemonade-crazed neighbors keep buying, cleaning out his supply. Demand-pull inflation at work in the neighborhood lets Little Johnny bike off into the sunset with his signed rookie card.

Bonus: Fiscal Policy        

In addition to our root causes there is a third origin for inflation that is often misunderstood: fiscal policy. Fiscal policy can create inflation; however, depending on the context of the policy fiscal policy induced inflation often falls under either the cost-push or demand-pull category.

Following the trickledown effects of discretionary or expansionary fiscal policy, you can often identify which root cause the policy is capitalizing on to create inflation. For example, deficit spending (expansionary fiscal policy) pumps cash into a particular sector with the intent of creating a demand-pull in that particular area of business. Fiscal policy itself does not create inflation. Rather, the policy uses supply and demand to encourage either demand-pull or cost-push inflation to occur, artificially inducing natural market forces.

I’ll be covering different types of inflation, why inflation can actually be a good thing and how to protect yourself from the negative aspects of inflation in later pieces so stay tuned!

2018-01-26T16:23:51+00:00 January 26th, 2018|Market Update, Newsroom|