Inflation is an economic term used to describe rising prices and a loss of purchasing power over time.
Written by Geoff Williams for Forbes Advisor
Inflation is an economic term used to describe rising prices of goods and services, and a loss of purchasing power over time. It occurs when consumers spend more on the same amount of goods and services today than they did a year ago, writes Geoff Williams, a contributor for Forbes Advisor. It is typically expressed as the annual change in prices for everyday goods and services such as food, apparel, transportation and toys.
When everybody pays more and gets less for it, it can have some profoundly devastating effects on the economy—and some consumers get hurt more than others.
“In every economic environment, there are winners and losers and inflation is no exception. However, the longer high inflation persists, the harder it is to find winners,” says Jeanette Garretty, chief economist at Robertson Stephens, a wealth management firm. “Ultimately, high inflation seeps into the nooks and crannies of every balance sheet and income statement.”
There are three primary types of inflation:
- Demand-pull inflation
- Cost-push inflation
- Built-in inflation
Right now, the country is dealing with all three major types of inflation, which is rare, according to Christopher Blake, assistant professor of economics at Oxford College of Emory University.
Demand-Pull Inflation – Demand-pull inflation describes how demand for goods and services can drive up their prices. If something is in short or disrupted supply, you can generally get people to pay more for it.
The U.S. is experiencing demand-pull inflation due to wages rising and Americans having a decent amount of money in their savings accounts, Blake explains, although some consumers are starting to empty those accounts.
“Consumer spending has remained high, despite the rising prices we currently see,” Blake says. “This is commonly referred to as demand-pull inflation, as consumer demand pulls prices higher because firms cannot keep up.”
Cost-Push Inflation – Cost-push inflation often kicks in when demand-pull inflation is going strong. When raw materials costs increase for businesses, the businesses in turn must raise their prices, regardless of demand.
“Increases to the prices that producers face put businesses in a tough spot,” Blake says. “They can either accept higher costs and keep their prices the same, or they can respond by trying to keep their profit margins the same.”
When the price of chicken keeps going up, for example, eventually your favorite restaurant will need to charge more for a chicken sandwich.
Built-in Inflation – As demand-pull inflation and cost-push inflation occur, employees may start asking employers for a raise. If employers don’t keep their wages competitive, they could end up with a labor shortage.
If a business raises workers’ wages or salaries and tries to maintain profit margins by raising prices, that’s built-in inflation.
Now, if you learn about your favorite coffeehouse raising prices due to the climbing cost of coffee beans, you’re a victim of cost-push inflation.
And if you’re going to buy that coffee even though the price is uncomfortably high, you’re engaging in demand-pull inflation.
3 Ways Inflation Hurts Consumers and the Economy
1. Less Purchasing Power
The most obvious impact of inflation is that it hurts your purchasing power. If you can’t buy as many goods and services as you did before inflation, your quality of living will eventually diminish.
Less purchasing power really hurts families that were already experiencing financial hardship. “Think more money spent on groceries and gasoline, and less spent on travel and entertainment,” says Angelo DeCandia, a professor of business at Touro University.
“Inflation hits the lowest-income families harder because items such as gasoline and food make up a much larger portion of their budgets, leaving less for discretionary spending,” says Dan North, senior economist at trade credit insurer Allianz Trade. “So, for example, where they used to have money to go out to dinner, even fast food, or [go to the] the movies once a month, now they won’t at all.”
A 2021 study from the University of Pennsylvania found that lower-income households had to spend about 7% more on goods and services last year compared to 2019 or 2020, while higher-income households had to spend 6% more. Remember, the annual rate of inflation for 2021 was 4.7%.
2. Less Savings
If rising prices for essentials is eating into your budget more than normal, you probably aren’t putting as much money into a savings account. A June 2022 Forbes Advisor-Ipsos survey found that 42% of respondents were saving less money than usual.
“Inflation makes all of our income and savings less valuable,” says Todd Steen, professor of economics at Hope College in Holland, Michigan.
If you’re not able to save as much as you used to, you may be less prepared for financial emergencies, forcing you to rely on costly credit cards or loans to pay unexpected bills.
And even if you have money in savings already, that decreased purchasing power means your emergency fund might not stretch enough to cover a financial crisis during an inflationary period.
If you have $1,000 socked away for a rainy day, you’re certainly better off than not having it. But here’s an example of how inflation can eat at the value of your savings.
Car repair prices went up 9% from June 2021 to June 2022 according to the CPI. If you had a $900 car repair in June 2021, in June 2022, that same car repair would have been $981. Suddenly your $1,000 saved up is a little less valuable.
“Inflation is a difficult problem to get rid of in an economy, because when prices increase, workers want to have higher wages and salaries to keep up,” he says. “This can lead to future price increases, and the cycle continues.”
3. Loss of Goods and Services
Some industries do pretty well during inflationary times, particularly ones in which you can’t hold off your spending indefinitely, like supermarkets, gas stations and funerals—but some businesses are completely devastated.
That’s because when inflation runs rampant, consumers spend their money on products and services that they absolutely need, and hold back on what they don’t.
You’re going to get your car repaired if you need it. You’ll keep spending money on food.
But you might not take your kids to a trampoline park. You might instead opt for a free city playground with the youngsters, instead. Decisions like that are understandable when prices are high but collectively, they can damage segments of the economy.
“That could mean your favorite pizza place closes, or your nail salon drops a service because it’s become too costly,” says Callie Cox, an investment analyst at eToro.
The renown economist Milton Friedman quipped that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced
only by a more rapid increase in the quantity of money supply than in output of goods and services. Consequently, empirical evidence suggest that, if growth in the money supply is greater than the actual growth in GDP, inflation results.
References:
- https://www.forbes.com/advisor/personal-finance/why-is-inflation-bad/
- https://www.nytimes.com/article/inflation-definition.html
- https://www.forbes.com/advisor/personal-finance/types-of-inflation/
- https://www.caixabankresearch.com/en/economics-markets/inflation/inflation-merely-monetary-phenomenon
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