What is inflation and why it increases

Inflation is when the prices of commodities increase in the economy. This increase in prices leads to a decrease in the purchasing power of the currency. It means what you can earn with USD 10,000 today is more than what could be earned with USD 10,000 after five years. That’s because the price index increases with time.

Further, there can be various reasons for the increase in the prices. Let’s discuss some of the main reasons for inflation.

Reasons of inflation

There are three main reasons for inflation that include demand-pull inflation, cost-push inflation, and built-in inflation. Let’s understand the concept in some detail. 

1- Demand-pull inflation

Demand-pull inflation is when the demand for the goods in the market is more than supply. There is some imbalance/gap in the aggregate supply and aggregate demand of the specific goods. The market responds to the situation by increasing the prices to ensure demand and supply remain in equilibrium. This leads to an increase in the price of goods and inflation.

So, the main drive of demand-pull inflation is “increased demand of the product.” The question arises why the demand for goods increases in the economy.

Why does the demand for goods increase in the economy?

The demand for goods increases in the economy due to multiple factors, including economic expansion, increase in exports, Government spending, and more money in the economy.

Economy expansion

The demand for the products increases with the growing size of the economy as consumers feel confident in their potential to earn money. Hence, they can spend more money easily. This leads to an increase in product demand.

Increase in exports

If there is a sudden increase in the export rate, It leads to a gap between supply and demand in the local market. Hence leading to the increased price.

Government spending

If the Government spends freely in the economy, more money enters the system and increases demand for the product.

More money in an economic system

More money in the economic system leads to an increase in purchasing power of the consumers. As a result, they spend more and consume more, leading to an increase in price/inflation.

2- Cost-push inflation

Cost-push inflation is when prices of the products increase due to an increase in the price of raw material and wages required for production. Since the producer of the goods has to incur more costs, this leads to an increase in the product’s price. Further, the higher cost of production leads to a decrease in the quantity of production and supply (this is because capital is limited). Hence, an economic scenario is created that reflects a supply shortage leading to an increase in the price.

It’s important to note that the production price of the product is not limited to raw material and labor cost but includes the cost of capital, land expenses, and cost of entrepreneurship, etc.

Example of cost-push

In 1970, the Organization of Petroleum Exporting Companies cut the supply of petroleum. This led to a shortage of petrol in the market and industry relying on petrol as input in the production had to incur higher prices. These companies, in return, increased the price of their products. This led to cost-push as the consumer had to ultimately pay an increased price.

3- Built-in inflation

It is when workers feel inflation in the economy and need to get higher wages to maintain the current living standard. So, this type of inflation is dependent on the expectation of the workers. Similarly, the producer of the goods feel inflation in the economy, and they increase the prices of their products to maintain a level of earnings.

So, it’s due to the psychological impact of general inflation or adaptive expectation as they have experienced the same situation in recent times.

Why inflation is increasing in the United States of America

The United States of America is facing a peak of inflation in recent times. The rate of increase is the highest one after 2008. Economists have sat together to discuss the reasons for the higher inflation in the United States. They’ve concluded three reasons for the higher costs in the economy, as discussed below.

Reopening of the United States

The United States has controlled the spread of a pandemic. Thanks to the vaccination of COVID-19, that led to control of the spread of the virus and death rate.

The country is going to reopen, and people are excited to travel, enjoy, and buy the products they could not do during the lockdown. So, these expenses of the people increase the volume of money in the economy and lead to an increase in aggregate demand for the products.

This increase in demand is leading to an increase in the prices of the products. Hence, this type is demand-pull inflation that is increasing due to an increase in demand for the products.

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