What causes inflation? Learn more about this factor

Inflation is a complex economic phenomenon that affects countries and individuals all over the world. It is a measure of the general increase in the prices of goods and services in an economy over time. When prices rise, each unit of currency buys less than it used to, which reduces purchasing power. Understanding the causes of inflation is essential for economic policymakers, companies and consumers, as it allows them to implement strategies to mitigate its negative effects. 

What causes inflation?

Inflation is an economic phenomenon that arouses interest and concern among economists, policymakers and ordinary people around the world. Understanding the underlying causes of inflation is fundamental to understanding its impact on the economy and everyday life. 

Demand and Supply

The relationship between demand and supply plays a fundamental role in determining the prices of goods and services in an economy. When the demand for a product exceeds its supply, prices tend to rise, while a greater supply than demand tends to lower prices. This balance between supply and demand is essential to understanding how prices are determined in competitive markets.

In the context of inflation, imbalances between demand and supply can contribute significantly to inflationary pressures. When the demand for goods and services exceeds the economy's production capacity, this is known as demand inflation. This can happen for a number of reasons, such as rising wages, economic stimulus policies that inject more money into the economy or changes in consumer preferences.

For example, if wages increase significantly in a certain industry, workers in that industry will have more disposable income to spend on goods and services. If the production of these goods and services does not keep up with this increase in demand, prices will tend to rise.

Similarly, economic stimulus policies, such as a reduction in interest rates by the central bank, can encourage consumers and companies to increase spending and investment. If the supply of goods and services cannot keep up with this increase in demand, prices can rise.

On the other hand, inflation can also be driven by imbalances in supply, known as cost-push inflation. This occurs when production costs increase and companies pass these costs on to consumers in the form of higher prices. Shortages of raw materials, rising wages, increased energy costs and disruptions in the supply chain are all examples of factors that can increase production costs and lead to cost inflation.

Monetary Policy

Monetary policy is an essential tool used by central banks to control the money supply and interest rates in a country's economy. The main objective of monetary policy is to maintain price stability and promote sustainable economic growth. In the context of inflation, monetary policy plays a crucial role in determining price levels and managing inflationary pressures.

There are various tools that central banks can use to implement monetary policy:

Interest rate

One of the most important instruments of monetary policy is setting the short-term interest rate. When the central bank raises interest rates, it becomes more expensive to borrow and more attractive to save, which tends to discourage spending and investment. This can help reduce aggregate demand in the economy and control inflation. On the other hand, if the central bank reduces interest rates, credit becomes more accessible and incentives to spend and invest increase, which can boost aggregate demand and potentially increase inflation.

Open market operations

Open market operations refer to the buying and selling of government securities on the open market by the central bank. When the central bank buys government bonds, it injects money into the economy, increasing the money supply and reducing interest rates. This can stimulate economic growth and increase inflation. On the other hand, when the central bank sells government bonds, it takes money out of the economy, reducing the money supply and raising interest rates, which can curb inflation.

Compulsory reserves

Commercial banks are often obliged to keep a certain proportion of their deposits as reserves at the central bank. Increasing compulsory reserves reduces the amount of money available for lending by commercial banks, which can help curb inflation by reducing the money supply in the economy.

Communication and future orientation

Central banks can also influence the expectations of economic agents through clear communications and forward guidance on their monetary policies. If consumers and companies expect the central bank to act to control inflation, this can influence their spending and investment behavior, helping to keep inflation under control.

Inflationary expectations

Inflationary expectations play a crucial role in determining current and future inflation. They refer to the beliefs and perceptions of consumers, businesses and investors about future levels of inflation and influence their spending behavior, investments and wage decisions. If inflation expectations are high, this can fuel a cycle of rising prices, while low expectations can help contain inflation.

There are several reasons why inflation expectations are important:

Anticipating Future Prices

If consumers and companies expect prices to rise in the future, they can anticipate these increases by making advance purchases or investing in assets that are traditionally a hedge against inflation, such as real estate or precious metals. This anticipation can in itself fuel an inflationary spiral, as prices continue to rise to keep up with inflationary expectations.

Wage negotiations

Inflationary expectations can also influence wage negotiations between workers and employers. If workers expect prices to rise in the future, they may demand higher wage increases to compensate for this loss of purchasing power. If companies foresee higher labor costs in the future, they can raise the prices of their products to compensate for these wage increases, thus fueling inflation.

Investment Decisions

Investors and companies also consider inflation expectations when making investment decisions. If they expect inflation to rise in the future, they may choose to invest in assets that historically do well in times of inflation, such as shares in companies that have flexible prices or commodities. These investments can help protect your assets from losing value due to inflation.

Monetary Policy

Inflationary expectations can also influence the effectiveness of monetary policy. If economic agents believe that the central bank will be able to keep inflation under control, this can help to anchor inflationary expectations and facilitate the effectiveness of the central bank's measures to contain inflation. On the other hand, if inflationary expectations are unanchored, this can make it more difficult for the central bank to control inflation, even with aggressive monetary policy measures.

Production costs

Production costs are a crucial factor in determining the prices of goods and services in an economy and play a significant role in inflation. Production costs represent the expenses incurred by companies to produce goods and services and include a variety of elements, such as wages, rents, raw materials, energy and other inputs.

When production costs rise, companies often pass these increases on to consumers in the form of higher prices. This phenomenon is known as cost inflation and can be an important driver of inflation. There are several reasons why production costs can rise:

• Wages: Wages represent a significant part of production costs for many companies. If wages increase due to pressure from unions, shortages of skilled labor or government policies, companies may be forced to raise the prices of their products to maintain their profit margins.
• Raw materials: The costs of raw materials can vary according to global supply and demand, supply shocks, currency fluctuations and other factors. If the prices of raw materials increase, companies that depend on them for their production will face higher costs and may pass these increases on to consumers.
• Energy: The cost of energy is an important component of production costs in many sectors, especially those that rely heavily on energy to operate. Increases in energy prices, whether due to changes in oil prices, government policies or natural disasters, can lead to increases in production costs and, consequently, in the prices of end products.
• Technology and Innovation: Although technology can help reduce production costs in the long term, initial investments in new technologies and innovations can increase costs in the short term. Companies may need to raise prices to recoup these investments, especially if they expect the innovations to result in better or more efficient products or production processes.

Economic Growth

Economic growth is a fundamental indicator of a society's development and refers to the sustained increase in the production of goods and services over time. Generally measured by Gross Domestic Product (GDP), economic growth is essential for improving people's standard of living, reducing poverty, creating jobs and promoting technological and social progress.

There are several reasons why economic growth is important and how it can affect inflation:

Employment and Income

Economic growth is generally associated with greater job creation and an increase in disposable income for workers. As more people have jobs and earn higher wages, the demand for goods and services tends to increase. This can lead to inflationary pressures if supply cannot keep up with the increase in demand.

Investment and Productivity

Sustained economic growth is driven by investment in physical capital (such as factories and equipment) and human capital (such as education and training). These investments can increase the economy's productive capacity and improve efficiency, leading to faster growth in the production of goods and services. 

However, if investment is not accompanied by improvements in supply, this can lead to inflationary pressures as demand outstrips the economy's production capacity.

Technological development

Economic growth is often associated with technological progress and innovation. New technologies can increase production efficiency, reduce costs and allow new products and services to emerge. This can stimulate economic growth and improve people's standard of living. 

However, technological development can also create challenges, especially if it results in rapid changes in the structure of the economy and the demand for different types of skills, which can lead to inflationary pressures in certain sectors.

Income Distribution

Although economic growth can increase income and living standards in general, it doesn't always benefit all segments of society equally. If economic growth results in greater income inequality, this can create social and political tensions that can affect economic stability and monetary policy. 

Furthermore, if economic growth is concentrated in specific sectors of the economy, this can lead to inflationary pressures in these areas.

Impact of Inflation

Inflation can have a number of impacts on the economy and society. Firstly, it reduces the purchasing power of families, as the same amount of money buys fewer goods and services. This can lead to a reduction in living standards and a redistribution of wealth from savers to debtors, since the real value of debts decreases with inflation.

In addition, inflation can distort economic decisions, leading people to spend earlier than planned to avoid higher prices in the future. This can result in inefficient allocations of resources and reduce the potential for long-term economic growth.

Strategies to Control Inflation

To control inflation, economic policymakers have a number of tools at their disposal. One common approach is the use of monetary policy, by adjusting interest rates and the money supply. Higher interest rates tend to discourage consumption and investment, helping to reduce aggregate demand and control inflation.

In addition, fiscal policies, such as raising taxes or reducing government spending, can help contain inflation by reducing aggregate demand in the economy. However, these measures can also have negative effects on economic growth and employment, which requires careful balancing.

A complex economic phenomenon

Inflation is a complex economic phenomenon, driven by a variety of factors, including imbalances in supply and demand, monetary policy, inflationary expectations and production costs. If not properly controlled, inflation can have adverse consequences for the economy and society as a whole. It is therefore essential that economic policymakers are alert to signs of inflation and implement appropriate measures to keep it under control.

See also: Rent Adjustment: How much is allowed by law?

March 31, 2024