In 1920, the cost for a bottle of Coca-Cola was a nickel and
the average annual income was less than $3,300. Fast forward a century to 2020
and both of these figures would be ludicrous. This is the basic effects of
inflation at work.
Inflation is the general increase in prices and decrease in the purchasing power of money over time. It usually refers to the purchasing power of money across the economy, but also takes place in individual sectors. An economy generally balances out the decrease in purchasing power with increases in wages, so while a dollar buys fewer goods, it also buys less labor. Price inflation becomes a problem if wage growth doesn't match pace. There are two main kinds of inflation in developed economies: Demand-pull and cost-push.
Demand-pull refers to the rippling effect caused by increased demand for consumer goods. As basic supply and demand dictates, when demand rises so do prices. This is inflation driven by consumers.
Demand also goes up as people's ability to buy and pay more rises. When wages rise, people have more money to spend. For example, they may use this extra discretionary spending money to buy new cars. This increases demand for cars which in turn raises prices. In order to keep up with the new demand, car manufacturers need to hire more workers. They raise wages in order to recruit enough employees, thus creating more discretionary spending money to be spent in other sectors, raising demand and repeating the process. This effect can ripple throughout an entire economy, causing inflation.
Cost-push refers to the rise in prices due to a higher cost of production. This is usually caused by an increase in the cost of wages or raw materials. Cost-push is inflation caused by producers.
With cost-push inflation, the demand for a good remains unchanged while the supply of a good declines due to the higher cost of production. This results in the rising price passed onto the consumer. Cost-push inflation is especially noticeable when it hits commodities like oil. Since oil is a major component of many different products and services, it can raise consumer prices across the board.
While demand-pull and cost-push are the main driving forces of inflation, there are other factors that make large impacts:
Money Supply: Think of the dollar like a collector's item. The rarer it is, the more valuable. If the U.S. Federal Reserve prints money and puts it into circulation faster than the economy demands, it diminishes the value of the dollar (and along with it, the purchasing power of wages).
National Debt: When the national debt is high, the government will either raise taxes or print money to pay it down. Printing money increases the money supply as explained previously, while raising taxes leads to higher costs for producers and therefore higher prices for consumers.
Exchange Rates: If the value of the U.S. dollar is less than that of an international trade partner, imported goods cost more to U.S. consumers.
Each of these happens independently of consumers wages, and if wages don't increase while the money supply, national debt, or exchange rates raise prices, the U.S. consumer's buying power is diminished and can cause the economy to slow.
Effects of Inflation
Although the most common effect of inflation is the rise of prices, there are other noticeable side-effects to the average consumer:
Interest rates rise: Typically, the Federal Reserve will raise the market interest rate to increase the cost of borrowing, ensuring too much money isn't borrowed, spiking demand and therefore prices.
Debt is cheaper: If the inflation rate is higher than your interest rate, you benefit by repaying the debt with less valuable money.
Saving is deferred: If the inflation rate is higher than savings rates, consumers are incentivized to spend money now rather than save for later.
Inflation: Good or Bad?
In an ideal world, cost-push and demand-pull balance one another out, raising wages and prices together to expand the economy and increase standards of living. However, problems can arise and economies stall when the cost of goods - especially necessities like healthcare, housing, and food - rise faster than wages.
The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.