Why Prices Go Up – Inflation Explained

As prices rise slightly year after year, most of us take little notice – it’s not until you look back and remember how much you paid for your milk, your newspaper or even your home, compared to the prices now, that you realize just how much prices have crept up.

This creeping is called inflation and is actually far more orchestrated and deliberate than you may realize since it’s something you don’t notice until long after it has happened. Inflation occurs in every country in the world and understanding how and why it happens can help you find ways to minimize its effects on your life.

What is inflation?

The rise in the prices of goods and services is measured by the Consumer Price Index. This inflation will affect each part of a country’s economy is a different way at a different time.

The movements of inflation in one area, will also affect the prices of goods and services in another, for example, where oil prices fluctuate rapidly because of the bidding on oil futures contracts, gas prices become very fluid as well. This in turn can increase the prices of food or other goods which are transported long distances.

While you may have heard your pay rise at work referred to as a cost of living increase, your boss will usually be increasing wages in response to inflation in order to retain good staff. However, wages don’t usually increase at the same rate as inflation.

The inflation rate is measured as an annual percentage increase, and when inflation rises, every dollar will buy you a smaller percentage of goods and services.

At the same time, the value of the dollar does not remain constant when affected by inflation and instead is viewed in terms of its purchasing power and when inflation goes up, purchasing power goes down.

There are also several types and variations of inflation:

  • Asset inflation. Inflation can also occur in isolated parts of the economy, for example a boom in housing prices is known as asset inflation because it affects just one asset class.
  • Deflation. When the general level of prices is falling this is deflation.
  • Hyperinflation. When inflation occurs very rapidly this is called hyperinflation and can cause the breakdown of a country’s economy – for example, when prices rose 2,500% in one month in Germany in 1923.
  • Stagflation. When there is a combination of high unemployment and the economy is stagnant, this is stagflation, which has occurred in industrialised countries in the 1970s when bad economies combined with OPEC raising oil prices.

Why does inflation occur?

There is no single reason for inflation and instead, it occurs due to a myriad and a patchwork of reasons and motivators, with each one having different significance in different economies. There are two main theories on why the factors of inflation combine the way they do to increase prices:

  • When there is too much money and not enough goods, demand is growing faster than supply and as a result, prices of the goods which are available rise beyond what they are truly worth.
  • When the costs to do business go up, businesses will also need to raise their prices to protect their profit margins, so as the cost of wages, taxes and imports increase, so do the costs of the products and services to the consumer.

Increases in the cost of living can result from a number of factors including:

  • Governments printing more money. Governments may try and deal with a crisis by printing more money and as a result, prices can rise very quickly in keeping up with the currency surplus. This is inflation due to an increase in price due to an increase in demand.
  • Raw materials costs increase. This is an example of inflation because of an increased cost of doing business, when raw materials increase in price, or rising labor costs mean higher production costs.
  • International lending and national debts. When a country borrows money, they pay interest as they repay the debt. As a result, prices need to rise so repayments can keep up with interest charges.
  • A drop in exchange rate. if there is a significant drop in the exchange rate, government have to deal with vast differences in import and export levels and this can cause inflation.
  • Federal taxes. When consumer products such as cigarettes or fuel are taxed, the price of these products increases as the taxes rise. When the tax rises, the supplier can’t absorb the increase and instead passes it onto the consumer. Unfortunately, even if the taxes go down again, prices rarely go down too.
  • War. As a way to recoup the costs of the war and the funds borrowed from the central bank, inflation will rise as international trading and labor costs rise.

How does inflation affect you?

When inflation causes prices to rise, you will find yourself paying more for the same goods and services. However, inflation is not always a negative factor and plays an important part in keeping the economy steady and progressing in the right direction.

When inflation rises are anticipated, banks will vary their interest rates and workers can negotiate wage increases to cover higher costs of living. However, when inflation is unexpected, it can have negative effects including:

  • When there is uncertainty about inflation companies and consumers are less likely to spend, and this damages the health of the economy in the long run.
  • If retirees or others living on a fixed income have no way to increase their income, they will find their purchasing power diminished, and be forced to change their buying habits.
  • When the inflation of one country is greater than another, domestic products become less competitive in the international market.

At the same time, inflation is a sign that the economy is growing and in some cases very little inflation, or even deflation, can be a sign that the economy is weakening.

Therefore, to make sure that inflation isn’t bad news for your purchasing power, make sure that your wages increase at the same rate as the inflation rate, and find out whether your long term investments will be able to keep up with, and exceed inflation costs, so they are of value when you need them for the future.

Alban is a personal finance writer at Home Loan Finder, a home loan comparison website.

2 Responses to “Why Prices Go Up – Inflation Explained”

  1. Zane July 29, 2011 at 12:44 am #

    With regards to factors like fuel prices, which fluctuate quite a lot but generally drive the price of Goods and Services up (and I’ve never seen them come back down after the fuel price has gone up), why isn’t the pricing regulated or tightly coupled to these sort of fluctuations in order to control inflation better? Administrative nightmare?

  2. Jerret July 29, 2011 at 5:42 am #

    Yep. It would be a disaster and would probably actually drive prices too much. I think a better idea is to set the government’s taxes at a fixed level instead of a percentage. I think we’d all be shocked to know how much the government takes. Especially on fuel.

    Thanks for the comment!