What causes inflation? Good question. Economists love to debate this topic round and round, and they have several theories. Oftentimes, some of these causes combine to create a single economic tsunami:
Too Much Money/Too Few Goods
Some economists believe too much money circulating with too few goods causes inflation. In a flourishing economy, this can happen. Companies can charge more for their products because consumers have plenty of money to spend and are willing to spend extra cash for a valued product. Companies see this high demand and raise prices in response. This leads to increased prices across the entire economy as other corporations follow suit.
Response To Cost Increases
Another theory behind inflation is that companies experience cost increases due to a variety of pressures-taxes, fees, penalties, restrictions intended to improve quality or to go green-and they pass the cost on to the consumer by raising prices instead of reducing profit margins. Sometimes these cost increases are related to labor costs or increased costs of supplies. The end result is consumers end up paying more for the same product.
Inflation is also related to the availability of credit. If credit is tight, as it has been in the latest credit crunch, companies can't afford to pay workers or purchase supplies. This can cause companies to do one of two things: either sell goods at fire sale prices or raise prices in order to maintain profit margins. This means companies try to do more with less, causing inflation and sometimes resulting in higher unemployment, since labor costs may be the first costs cut. When credit becomes available again, companies rehire and begin spending again, and then the concern about profit margins decreases, allowing prices to come back down again.
Stock Market Performance
The stock market also affects inflation. When investors feel confident and are investing in the stock market, consumers are usually also more willing to buy. This can contribute to a healthy growth of both inflation and wages. When stock performance is poor and investors and consumers alike save their money instead of spending, we see a shrinking of the economy.
Did you know there are several types of inflation? Each type of inflation affects the economy differently. In order to understand the effects of inflation, you need to understand what inflation is and how it works.
If you're looking for a hedge against inflation, you will want to search for investments that either have high enough returns that they outweigh the effects of inflation or are geared to compensate for inflation.
Knowing how taxes affect inflation can help you make informed decisions when it is time to vote on tax hikes or for the politicians who represent you.