money surround a cardboard sign that says inflation

How Inflation Works: Inflation Explained In Simple Terms

Inflation, inflation, inflation… Everyone is talking about inflation and everyone has a different explanation for why inflation is so bad right now. Republicans blame Joe Biden, and Democrats blame corporate greed. If you don’t understand how inflation works or why the prices of everything keep going up, it’s not surprising. Everyone has their own opinions about what’s causing inflation — even the experts don’t agree — but, understanding how inflation works is not that difficult. 

If you’re looking for an easy explanation of how inflation works, keep reading. I am going to explain inflation in simple terms so that anyone can understand. Then you can sort out for yourself what is really to blame for inflation.

What is Inflation?

Unless you’ve been living in a cave, or don’t buy groceries, gas, or pay rent, you probably know that just about everything you buy has gone up in price over the last year or so. This increase in prices is caused by inflation, an economic word that basically means prices on everything have gone up.

To put it simply, inflation means that the overall cost of goods has increased over a period of time. Your purchasing power, or how much your dollar can buy, has gone down while the price of everything has gone up. 

What you used to be able to afford for a dollar now costs more than that, making money you have worth less.

You really don’t have to be an economist to understand inflation. Just go to the grocery store and compare the prices of things you buy over a period of time. If one or two items start to cost more, this isn’t necessarily because of inflation, but if you start to see that everything you buy has gone up, this is a result of inflation. 

How is Inflation Measured?

We measure the prices of things to see how much they go up over time, and that tells us what the rate of inflation is. But, how do we keep track of all this information? The government uses consumer surveys to track how much everything we buy costs. 

Government agencies select households to help them track the prices of everything that people buy. These households write down how much they spend on all the items they purchase for a couple of weeks, and then the government uses this information to determine what consumers are buying and how much they pay for things.

They compile all of this information to determine how much inflation goes up or down each month. The data they collect is an indicator (or index) of what is going on with inflation. We use three main indexes to measure inflation — the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumptions Expenditure Price Index (PCE).

These indexes measure how much we, the consumers, pay for products and how much it costs producers to make the goods they sell to us. They also measure other expenses such as healthcare costs and employer contributions made by businesses.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is the most commonly used index to measure inflation. The US Bureau of Labor Statistics keeps track of how much consumers pay for goods and services every month. They break this spending down into 8 categories that represent what consumers generally buy. These include food and beverages, housing, clothing, transportation, medical expenses, recreation, education, and other goods and services.

If you’re interested in seeing which consumer goods are most affected by inflation, you can read their reports here

Producer Price Index (PPI)

The Producer Price Index is similar to the Consumer Price Index, but instead of tracking how much consumers spend on stuff they buy, it tracks how much producers spend on the goods and services they buy to make the products they sell. Like the CPI, the government collects surveys to track the cost of everything. Businesses in different sectors provide the US Bureau of Labor Statistics with information on how much their costs are. 

Businesses may have higher costs to make their goods for lots of reasons, like the cost of transportation going up or not being able to find the supplies they need. If the cost of making goods goes up, the price the consumer pays will also go up.

Personal Consumption Expenditures Price Index (PCE)

The Personal Consumption Expenditures Price Index (PCE) is another index published by the Bureau of Economic Analysis. It tracks consumer spending a little differently than the CPI. The CPI tracks inflation based on household surveys of consumers but the PCE doesn’t rely on surveys to track inflation. 

It uses GDP figures (or the total value of goods and services produced in the country) to track inflation. This provides a much more precise measurement of inflation, which is why it is the Federal Reserve’s preferred method for measuring inflation.

There are advantages and disadvantages to both methods of tracking inflation. The CPI provides specific information on the cost of goods in different categories, but the PCE is more accurate for calculating overall inflation.

What causes inflation?

If you want to know what causes inflation, the answer isn’t Joe Biden or Donald Trump. It’s a little more complicated than that. One person, including the president, doesn’t control the entire economy and isn’t the sole cause of inflation. There are many factors that contribute to inflation but there are three primary causes. 

An Increase in the Money Supply

Every country has a different amount of cash, coins, and money in people’s bank accounts which all add up to their total money supply. A larger money supply can often lead to inflation – because each dollar is worth less! This is why increasing the money supply is one of the biggest ways to cause inflation.

When the government prints more money, people, businesses and banks now have more money to spend on things. With more money to spend, people are able to use their money to buy more items. If the supply for everything they want to buy stays the same, companies will charge more for their products to match the high demand. Thus, driving up the cost of goods and causing inflation.

Increasing the money supply is a fairly easy process for the government. They can just print more money if they need it, unlike the rest of us. But, they don’t actually have to print new dollar bills to increase the money supply. They can do this all through digital transactions from the Federal Reserve (the United States central banking system).

The Federal Reserve (where US banks get their money from) is responsible for managing the money supply and setting interest rates. They don’t actually print money though, that is handled by the US Treasury. But, our money supply isn’t set in stone. The Federal Reserve can just make more money when needed. 

The banks can expand the money supply as well. You might think that the bank has to keep money on hand to cover all the deposits, but they only have to keep a fraction of it in their bank. Most transactions are handled electronically. This allows banks to expand the money supply as well simply by loaning it out. 

Demand-Pull Inflation

When everyone has more money to spend, it can sometimes lead to something called demand-pull inflation. Imagine if all of a sudden, everyone has more money to spend. What do they do with this extra cash? They go out and buy something they really want – like a new flat-screen television. But, what if everyone decides to go buy a flat-screen at once? When the supply of televisions decreases and nobody can find a television, retailers respond by raising the prices. This is because some people are willing to pay more to get an item they want, and may have more money to spend on it.

Demand-pull inflation can be caused when there is a reduction in the supply of goods and services, or when people have more money to spend on them. When demand for goods or services is higher than what manufacturers can produce, prices go up, causing inflation.

Cost-Push Inflation

Cost-push inflation happens when the producers of goods or services have to spend more in order to produce their products. For example, if a manufacturer can’t find the supplies they need to make their products or has to pay more for them, they will add the extra expense to the price of their goods, making them cost more. Or, if they have to pay more for labor, they will add the extra cost to the price of their products, making it higher.

In other words, sometimes it doesn’t take an increased demand for items to get pricier – inflation can be caused by extra expenses that producers pass on to customers.

Built-in Inflation

Built-in inflation happens when the cost of living goes up due to demand-push or cost-pull inflation. When this happens, workers now need more money to live on. When workers see no end to inflation, they will push employers for higher wages. When wages go up, however, companies may increase their prices to cover the costs of the higher wages they need to pay their employees. This can cause a vicious cycle that can be difficult to break.

When companies increase wages, they respond by increasing the prices of their products to cover labor costs. This drives up the costs of their products, leading to more inflation, and employees requiring a pay raise once again to compensate for inflation.

It may be Easy to Understand How Inflation Works, but more difficult to fix.

Understanding how inflation works and what causes inflation is not all that difficult. Politicians tend to fixate on one cause of inflation, without looking at the entire picture. Generally, there is more than one factor at play when we see inflation. Unfortunately, sometimes the best way to address inflation isn’t the easiest way. 

Take a look at the three main causes of inflation – an increase in the money supply, demand-pull inflation, and cost-push inflation. Do you see how many of these things have happened over the last year or so? These were largely caused by government policies and spending rather than decisions made by individuals and businesses. 

Libertarians like me want people to look at the total picture of what’s causing inflation. We need to start pressuring Congress to stop doing the things that cause inflation – like spending more money to “reduce inflation” and printing money to stimulate the economy. All of these factors have contributed to the inflation we are experiencing right now.

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