Did you realize the basic black tee you bought a year back is now a little more expensive than before? Well, this is what inflation does. If you don’t know what inflation is and don’t have any interest in reading economic articles with heavy jargons, then remain here because we will brief you about the topic in a language that you understand.

In this write-up we will talk about: what is inflation, its causes, and how does it affect the economy.

Before anything else, let us tell you that in an inflationary economy, which of the following statements are true.

  • The rise in the price level
  • Excessive money supply
  • Result of actions and interactions of economic forces
  • Cynical movement of prices

If we look at the above list, rise in prices, excessive money supply, and results of actions and interaction of economic forces are primary features of inflation. However, the cynical movement of prices doesn’t come under the banner of inflation.

Well, what is inflation, and how does it affect the economy?

Inflation and its types

Inflation occurs when the purchasing power of the consumers decrease. It is a quantitative estimate of declining consumerism that results in an increase in the average pricing of goods and services over a certain period.

There are two types of inflation; cost-push and demand-pull. Cost-push inflation occurs when the cost of production increases, which increases the prices of a particular good or service. On the contrary, demand-pull inflation is when the demand for a particular product or service is high, yet the supply is low. It leads to an increase in the cost of the demanded product.

What are the primary causes of inflation in an economy?

As we are aware of the two primary types of inflation, have a look at what drives them. Cost-pull inflation occurs due to the rise in the prices of raw materials. If raw materials such as metal, oil, cocoa beans, etc. get expensive, the prices of the finished products will also increase automatically. For example, if cocoa beans get expensive, all the products that use cocoa beans as raw material will also see a hike in prices simultaneously.

You can relate this effect to the domino effect. If one tile falls, the whole row will fall. On the contrary, in demand-pull inflation, high demand and lack of supply hike up the prices. It occurs when the employment rate is at its best. A higher employment rate will increase consumer confidence to spend. It would lead to an economic expansion, which will directly increase the demand.

When demand increases and the supply is low, the consumers will pay higher prices to obtain the products, which will eventually lead to an increase in the prices.

Overall, the hike in prices will affect not only consumerism but also the economy as a whole. Let us see what the effects of inflation on the economy are.

Effects of inflation on the economy

Regardless of the type of inflation, it surely affects the economy as a whole. We have listed the primary effects of inflation on the economy. Let’s see in an inflationary economy, which of the following are true.

Inflation directly affects the distribution of wealth and income. An economy is a result of multiple industries and businesses along with consumerism. If the distribution of wealth and income is uneven, some individuals will lose their fortune, while some will heavily benefit from it.

Farmers, traders, businesses, black markets, producers, and investors benefit from inflation, while creditors, debtors, and salaried people suffer.

As the cost of production increases, the producers pass on the added value of production to the consumer, which leads to a decrease in consumerism and an increase in supply. On the contrary, it benefits producers as they can utilize all the available resources and may increase their stocks for further profit. However, sometimes, even though the demand is high, the production remains stagnant, leading to stagflation.

Other than this, inflation also affects employment. Although employment may rise as more people will be required for production. However, the gross income may fail to increase proportionally resulting in poor purchasing power of consumers. Not only this, but businesses and trade cannot avoid the effects of inflation as well.

When inflation rises, imports tend to increase and exports tend to decrease. It is due to the increase in income, which positively affects the buying power. Secondly, the production or output of the economy stays at an all-time high during this time. However, the prices of goods and services may skyrocket, but the income rises disproportionally, which leads to businesses expanding and making more profits while consumerism decreases.

Other than this, inflation also affects government funds and economic growth. Due to inflation, the government may increase taxes, which would increase government funds. However, as people are less likely to be able to afford certain things, the government will have to rescue them causing a rise in public spending.

Moreover, runaway inflation can pull the economy down, as the cost of development will increase. However, if there is mild inflation, it will promote economic growth.