What causes inflation?

Inflation is the rising cost of goods and services. But inflation is particularly dangerous as it is the loss of purchasing power to consumers. In this article we discuss the main causes of inflation.

Cost push inflation:

One way inflation is caused is the “cost push”. This occurs when companies have increased costs associated with producing a product and pass this on to the consumer to maintain their profit margin. Increased costs can come from raw materials, energy, transport, or employee wages. For example, if the cost of oil is increased, this will affect the cost of production, it will also affect transport costs. Companies will pass on these costs to consumer making the product more expensive which contributes to inflation. Wages are also a significant cost to companies so if consumers are struggling with the increased cost of living, they may go to their employer and ask for a wage rise. This in effect makes the goods more expensive as the company will then pass this on to the consumer.

Demand-pull inflation:

Another cause of inflation is “demand pull” inflation. This is caused when the demand of goods exceed the supply. This pushes the prices of the goods up as consumers are willing to pay more for these goods as there is not enough supply. In an expanding economy where consumer sentiment is optimistic, this can cause increased demand. Reduced income taxes and low interest rates can cause increased demand for goods and services as consumers have more disposable income to spend. Households were saving a lot of money during the Covid lockdowns. Consumer spending on eating out or shopping was significantly reduced. When we came out of lockdown, there was strong demand for goods and services as households had large amounts of cash savings. However, the lockdowns caused a range or supply issues and we ended up with demand for goods and services surpassing supply.

 

Lauren Hua is a private client adviser at Fairmont Equities.

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