Because inflation affects everything in the economy, from the price of a cup of coffee to the size of the national debt, understanding how price inflation works may help you make better spending and investing decisions.
Definition and Examples of Price Inflation
When demand in an economy increases, prices go up. This is known as price inflation to the general public and demand-pull inflation to economists (because demand pulls up prices). Price inflation is based on changes in prices that consumers pay rather than changes in input costs or wages. One indicator for price inflation is the Consumer Price Index (CPI). Each month, the Bureau of Labor Statistics (BLS) tracks prices for goods and services throughout the economy, ranging from a loaf of bread to a haircut. The BLS uses this information to see how much prices have changed. Then, it looks to see why prices changed.
Alternate name: Demand-pull inflation
If a price increase was due to an increase in demand, then price inflation occurred. For example, in the spring of 2020, the pandemic and state regulations forced many people to stay home, which reduced demand and spending on goods and services outside of their house, such as takeout food and haircuts. Over the next year, as people became vaccinated and states lifted regulations, people returned to spending at pre-pandemic levels, and prices began to increase because of the increased demand for goods and services.
How Price Inflation Works
Price inflation is a function of simple supply and demand for goods and services. When demand increases but the supply of goods or services does not, prices increase. Many factors can contribute to an increase in demand. If an economy has an increase in population, then demand will increase because more people need more goods and services. This can lead to price inflation (all else being equal). Likewise, good news like an economic recovery or resolution of a political crisis might cause people to get excited about spending, with pent-up demand leading to price inflation. Of course, the world is not perfect, and an increase in demand may be accompanied by other factors. For example, in 2020, the U.S. government distributed stimulus checks to eligible individuals to provide economic support during the pandemic. Because of this, some people had more money to spend. Demand was already on the rise again, and this just added to it. By 2021, supply chain issues began driving up the costs of some inputs, and worker shortages led to increased wages. It was not just one thing that caused price inflation, it was several.
Cost Inflation vs. Price Inflation
Cost inflation, sometimes called cost-push inflation, involves increases in input prices that push up consumer prices. For example, if oil prices increase, transportation costs increase, and then prices throughout the economy are likely to increase since transportation is needed to move goods around the country to stores and people. These costs will increase even if demand stays the same. Cost inflation may also occur due to increases in producer or government demand. However, they are not driven by changes in consumer demand like price inflation. In fact, the resulting price increases may cause consumer demand to fall as people put off purchases or choose to buy less-expensive goods instead.
Notable Happenings
In the fall of 2021, the U.S. economy showed price inflation due to post-pandemic increases in demand. It was not the first time that the country experienced price inflation. A July 2021 White House analysis looked at several inflationary periods in the U.S., including the late 1960s, when many post-war babies started entering adulthood. They spent money on cars, houses, and work clothes, driving up demand and price inflation. While 2021 saw the same type of price inflation, the analysis showed it was not a new phenomenon, and that it’s sure to happen again in the future.
What It Means for Individual Investors
If you’re an investor, price inflation can be good or bad, depending on the types of investments you have. Inflation of any sort usually signals an increase in interest rates, which is bad for bond owners, but good for those looking to get more out of their savings accounts. Equity investors may have different experiences. Companies that deal with consumers often benefit from price inflation because their revenues go up as a result of the increased demand. However, their costs may not go up as much, giving them a nice bump in profit margins. Companies that mostly deal with businesses won’t see as much benefit from price inflation unless something changes their demand scenario. For example, an accounting firm is unlikely to see a change in supply or demand from consumer price inflation, but an advertising agency might as consumer product companies try to satisfy demand and take advantage of increasing profits. Long-term inflation may be good for investments that represent stores of value, such as real estate and precious metals. Many investors stock up on these assets because they tend to increase in value at the same rate as inflation. However, the value of an asset like gold may also be speculative, so take caution before investing your money. Do your research and consult a financial advisor.
