(When talking economics, it is especially important to bear in mind that everything influences everything else. And that there are leads and lags to these interactions. For a better understanding of the below, please read
We all know inflation is the thing that makes our salaries grow smaller and smaller. But what causes it? How do we stop it?
There are two kinds of inflation
The goods and services that we buy every day. This is watched very closely by reserve banks, politicians and every consumer on a fixed income.
The second is asset inflation, which I think is not watched closely enough. This is changes in the prices of houses, shares and other investments.
There is a lot of information about the causes of inflation. I would like to summarise it into two main areas:
Demand pull inflation
This is when there are more people that want to buy goods, than what goods are available for sale. There can be many causes for this - disruptions (natural or manmade) in the supply of goods, or increases in the amount of money available to consumers. Money supply increases can be because of better wages/ wage agreements, because banks are increasing their lending, or because the reserve bank is lowering interest (making it cheaper to borrow) in an effort to stimulate the economy.
Cost push inflation
This is when there are increases in the costs of producing goods, either in the materials needed, or in the cost of labour that is needed. Material costs can be heavily influenced by exchange rate changes.
Underlying both these causes, is the ability of an organisation to increase it’s prices. If there are many sellers, a particular seller would be hesitant to increase their prices, for fear of loosing sales to competitors. In America today, there are many industries with only a few major suppliers, which makes it easier for them to increase their prices. Whether it is because of demand pull, or cost push.
How to stop inflation?
There is consensus in modern economics that a little bit of inflation (+/- 2%) is good for an economy.
In very simple terms though, if inflation is too high, the way to stop inflation is to remove the cause of inflation:
either the excess money supply is reduced by increasing interest rates. This is usually managed by the reserve bank of a country.
or, the cost of goods needs to be reduced, usually by improving the supply of goods in the economy. Ruling governments typically do this through various kinds of economic incentives or other interventions.
HOWEVER, the big question is always: which of the above causes are at play in the economy. It is not always (actually, never) clear which of the above is the cause, and which of those is dominant.
I will add a more in-depth analysis of this in a future post.
Inflation