Why Does Inflation Occur?

Inflation occurs when prices increase over a period of time. It’s tracked through the consumer price index (CPI), which means the cost of goods year over year. For example, if a movie ticket costs $10 one year and $11 the next, it has a 10% inflation rate. Inflation can affect everything from the price of eggs to housing. It also sends ripple effects through the stock market and employment rates.

There are multiple categories of inflation and causes of this economic trend. Learning about inflation from reputable sources can help you better understand this concept and how it affects your buying power. Here are a few reasons why inflation occurs and examples in the modern economy.

1. Supply Shocks

A supply shock is an event that suddenly changes the ability of companies to manufacture and distribute products. Supply shocks can affect specific industries or the entire supply chain — like a global pandemic.

Crude oil is prone to supply shocks because it often comes from politically unstable countries. If American relations with an oil-producing country are tense, imports drop, causing prices to skyrocket.

Individual industries can overcome their own supply shocks, but the government may need to intervene to restore import levels if the shock is on a national scale.

2. Lower Interest Rates

Interest rates determine how expensive loans are, which can increase or decrease spending power. When interest rates are low, large purchases like homes are more affordable because buyers don’t pay as much to their banks. When rates are high, taking out a loan becomes more expensive, reducing overall buying power.

Interest rates can cause inflation to increase or decrease, and vice versa. They can naturally fluctuate with inflation or federal agencies can adjust them to change economic patterns.

3. Increased Demand

Increases in demand without increases in supply can cause inflation. For example, demand for housing is high across the United States, but it’s particularly high in California. This causes housing costs to increase because buyers are willing to pay more to live in certain areas. If housing inventory were to increase or demand decreased, prices could go down.

Though governing bodies can work to address housing deficits, buyer and seller behaviors also affect these trends. Sellers have to accept that home prices might fall while buyers could change their minds if interest rates are too high.

4. Rapid Economic Growth

Countries occasionally experience rapid growth that exceeds expectations. Bull markets can make investors feel confident and increases in spending power can help consumers. And though growth is considered good, it comes with drawbacks. Some industries might experience higher rates of inflation as companies charge customers more.

Inflation is a normal part of growth. The Federal Reserve even sets a 2% inflation target each year. However, economic leaders need to make sure inflation doesn’t get out of hand.

5. Increases in Production Costs

Companies are sensitive to changes in the pricing of the materials they use and the cost of labor. When the cost of production increases, companies will raise prices to account for these higher expenses.

For example, bird flu caused the cost of large eggs to increase from $0.95 to $3.89 per dozen in 2023. This impacted countless businesses from national bakeries to mom-and-pop diners. Many companies increased their prices because the cost of eggs suddenly decreased their profitability.

Production costs can stabilize on their own, but sometimes they require government intervention. For instance, governments might cover the cost of training programs or increase immigration efforts to reduce labor shortages. This keeps the cost of labor low.

6. Supply Chain Disruptions

Supply chain disruptions are when goods and services can’t reach manufacturers and customers. This occurred during the COVID-19 pandemic when ports were closed and factories were shut down. This disruption caused supply to drop because consumers couldn’t get the goods they needed. During this time, prices increased because companies have to charge more to move products and consumers are willing to pay more to receive them.

Supply chain disruptions can occur because of natural disasters, political disruptions, and worker strikes. To prevent these disruptions, governing bodies need to make an effort to keep supply chains moving and maintain positive trade relations with other countries.

7. Currency Depreciation

International markets can also affect inflation. If a country experiences economic or political instability, the value of its currency decreases. This means buying goods in that country is cheaper because one American dollar goes farther when converted.

For example, as of August 2024, the dollar and euro were almost equal. However, the exchange rate in 2020 was nearly $1.25 for one euro. If the dollar drops again, then buying goods in the European Union will be more expensive for Americans.

Each government does its best to have a strong currency by developing a healthy economy and stable political system.

8. Expectations of Future Inflation

Sometimes the expectation of inflation can trigger inflation itself. If businesses think inflation is on the rise, they may pre-emptively raise prices. If consumers expect inflation, they may be more willing to accept higher prices because they feel like they’re inevitable.

In 2024, Gallup found that 41% of consumers named inflation their top financial concern — the top response for three years running. It’s up to governments to communicate inflation expectations and calm citizens. For example, in July of 2024, Jerome Powell, the Chair of the Federal Reserve, assured Congress that the economy was no longer overheated and had stabilized.

9. Expansionary Fiscal Policies

These are government policies that are designed to boost the economy. Tax cuts and drops in interest rates are both designed to increase the spending power of individuals and corporations, for instance.

These policies can contribute to inflation or deflation by changing fiscal behaviors. When interest rates increase, spending often decreases and demand drops. Lower interest rates can boost demand, reducing supply and increasing prices.

10. Changes in Regulations or Taxes

Adjustments to fiscal policies often refer to changes in regulations and taxes. Government leaders might impose new tax laws to increase revenue or decrease taxes to give businesses and individuals more spending power.

Changes to taxes and regulations can be made due to inflation in an effort to change inflation rates. However, inflation can also change as a result of new tax policies. Both elements affect each other.

11. Changes in Trade Agreements

Governments work with individual countries to establish trade agreements. These usually include reduced taxes and tariffs in exchange for receiving goods. The U.S. has free trade agreements with 20 countries, including Mexico and Canada.

When trade agreements change, like a country suddenly charging more to import goods, companies have to pay to receive the materials they ordered. This makes production more expensive, causing prices to rise. A new trade agreement with a major trade partner, like China, can affect inflation as a whole because countless industries are affected.

12. Changes in the Prices of Key Commodities

Key commodities refer to goods that are essential to society. These include oil and gas, wheat and corn, and livestock. Without adequate produce or livestock production, Americans would struggle to eat. Without oil and gas, most people cannot get to work or move supplies around the country.

Not only can changes in key commodities affect the entire country, but they’re often used as indicators to evaluate the economy as a whole. If prices of key commodities increase, expectations for inflation might also rise. Governments occasionally develop subsidies for key commodities to keep prices low. They also keep reserves in place in case there are unexpected shortages.

Inflation can have a singular cause like a supply shock or several causes that work together to change market prices. Knowing the causes of inflation can better help you identify trends and make economic predictions.