5 Possible Causes of Inflation & Its Consequences

"Inflation", you might have read or heard this word often in the Economic section of a newspaper or a news channel.

Inflation is one of the metrics to measure a country’s economy. It is a measure of the rate of increase in the pricing of goods and services.

Let’s say, in 2021, a kg of Apple was ₹100. In 2022, the price went up to ₹120. So, that would mean inflation of 20%.

In calculating a country’s inflation, many products and services such as housing, food, transportation, clothing, medical, and others are taken into consideration. Next, the prices of these products and services are taken into a group and the rate is calculated in percentage, keeping that year as a base year.

As the inflation rate increases, the cost of living will also increase. However, the average income remains constant.

This way, the majority of the country’s citizens may find it hard to balance the cost of living leading to a financial crisis.

So, what can be the possible causes of inflation? This article lists various causes of inflation and the consequences of worst-hit inflation.

Inflation can be caused because of various reasons with demand-pull and cost-push inflation being the most common. Besides this, a country’s economy can also be shocked due to various factors as discussed below:

1. Demand-Pull Effect
2. Cost-Push Inflation
3. Devaluation of Currency
4. Increase in Money Supply
5. Wage Push Inflation

1. Demand-Pull Effect

As the name suggests, this effect is associated with the growing demand for goods and services. demand-pull inflation may occur when the demand is higher than the economy’s ability to meet those demands.

With increasing demand, the prices may rise and the consumers will have to purchase at those prices causing disbalance in the economy.

Take an example of a music concert. If the number of seats is less and the demand is high, the ticket prices would eventually be increased and sold to the ones who can pay for them.  

Demand-pull inflation usually happens in a growing economy and is not always a negative sign. In fact, the Federal Reserve suggests that inflation of 2%-3% is considered healthy for the economy.

2. Cost-Push Inflation

This is one of the most common reasons for inflation and increasing prices. When the cost of manufacturing or raw materials increases, the companies will increase the product prices to meet the profits. This increases the burden on the consumers as the prices are controlled by the companies or the industry.

Cost-push inflation may happen if the government has increased the taxes on certain materials or the new laws have made imports or exports expensive.

The other possible reason could be the increase in taxes. If the government has hiked certain taxes that may affect the corporations, they are likely going to increase the pricing to meet the production costs.

3. Devaluation of Currency

Devaluation is defined as the lowering of a currency’s value, which then reduces the currency exchange rates. Devaluation affects inflation indirectly.

When the currency value lowers, the export rate becomes cheaper resulting in increasing exports to the foreign countries. Further, the import rate increases and the devalued country results in increased imported products.  

As a result, the citizens turn toward domestic products, increasing the demand. When the demand surpasses the production, the cost increases, resulting in the demand-pull effect.

The recent economic crisis in Sri Lanka with an inflation rate of 17.5% is attributed to the devaluation of its currency.

The Economic Outcomes of the Suez Canal crisis

The ship which was blocked for days at the Suez canal has cost losses of billions. Let’s understand the severe effect on the economy and the global trade

StartupTalkyAlan Joseph

4. Increase in Money Supply

An increase in the circulation of currency can be one of the major causes of inflation. Printing or circulating excessive money is never a solution to support the falling economy.

Printing more notes, cash, or coins that country’s economic growth is only going to devalue the currency and bring it down.

The lower the costs of export, the higher will be the dollars and foreign buyers.

Again, this results in demand-pull inflation increasing the costs of production. This, in turn, puts financial pressure on the citizens of the country resulting in higher prices and increased inflation.

One such example is Zimbabwe’s increased money supply in 2008.  The country was already in debt when its government decided to increase the money supply.

Due to the increased circulation of currency, the demand skyrocketed resulting in a shortage of supplies. As a result, the cost of production increased and the suppliers had to raise the prices.

The government then tried to control the prices of basic goods, but this cost was much lower than the cost of production. And, the supplier wasn’t left with many production units.

In 2008, the country’s inflation rate reached a shocking 231,150,888.87% causing hyperinflation.

5. Wage Push Inflation

An increase in the average wages of the workers or employees can be a contributing factor to inflation.

Higher wages and the increased cost of production are tied in a circular loop. If the rise in wages is high, the companies will have to increase the costs of production or adjust to the lower profitability. This is a case of cost-push inflation. Now, if the wages are increased, the companies may cut off the employees and this will only increase unemployment.

That said, the general rise of wages to keep up with the increasing inflation will have put less pressure on the economy.

What are the consequences of Inflation?

As inflation continues to grow, it may affect your cost of living, investments as well as future retirement plans.

The increasing prices may reduce the consumer’s purchasing power cutting off the costs of living. In worst-hit inflation, the citizens may even fail to meet the basic necessities.

This would result in lower profits, higher layoffs, and an increased rate of unemployment. To combat this, the countries may seek loans from the World Bank, IMF, and other financial organizations.

Further, the growing economies may lend loans to the countries facing hyperinflation with higher interest rates. This may lead to higher debts and worsened inflation.

Conclusion

Inflation can make or break a country’s economic growth. Optimal inflation of 2%-3% is considered positive whereas the inflation rate of 50% or above in a month can result in hyperinflation.

The above-mentioned causes of inflation should be regularly checked by the government and the financial institutions in the nation. The balance between demand-pull and cost-push would bring stability to inflation.

FAQs

What are the 5 causes of inflation?

Demand-Pull Effect, Cost-Push Inflation, Devaluation of Currency, Increase in Money Supply, and Wage Push Inflation are the 5 causes of inflation.

What are the main causes of inflation in developing countries?

Government spending, money supply growth, world oil prices, and the nominal effective exchange rate are the main causes of inflation in developing countries.