What causes inflation to occur in the first place?

Simply defined, inflation is an increase in the money supply. Money is no different from other commodities that are also governed by the laws of supply and demand. When there is more money chasing the same amount of goods and services, there is inflation. This causes the price of the goods and services to rise.

It is not uncommon to confuse cause and effect when it comes to inflation. Often when there is a noticeable increase in prices, inflation is blamed, but this may not be correct as there can be other explanations for rising costs. The causes of inflation can be lumped into two general causes: it’s caused by higher demand for good/services leading to higher prices — or alternatively, it’s caused by the government is printing too much money, meaning the money can buy less. In the end, inflation is all about supply and demand.

1) Inflation and Rising Prices Cause and Effect.

To authentic the relationship between prices and inflation, the definition of price is essential. Price is a free-market mechanism to affirm the information about the scarcity of any given commodity or service. Prices fluctuate sometimes on a daily basis. In general, if supply is up and demand is down for something it will be reflected by having a lower price. The opposite would be revealed by a higher price.

There are other determinants for rising prices, and the most critical one is the increase in the supply of money, or inflation. The same attributes apply to money as they do to a commodity or service. A higher supply of circulated money, usually issued by a central bank will cause inflation, and the resulting effect is rising prices. Usually during a time of inflation, prices first rise and are then followed by wages. This sometimes causes a misinterpretation of cause and effect. The cause of inflation is the growth of the money supply, and the effect is the rising prices. When this occurs slowly, supply and demand is not affected in any great significance, but the rapid escalation of fiat currency can grind an economy to a halt, as both buyers and suppliers are hesitant in taking decisions regarding transactions and are unsure what prices should be applied.

During an unusually high inflationary period, buyers may over purchase in fear of future rising prices for the same goods or services. This often causes an anomaly in the supply of inventory that often results in recessions or worse.

2) Monetary Policy and Inflation.

The monetary policies of nations determine the value of their respective currencies. Because money is no longer tied to gold, nations must float their currencies against each other to determine their value. An accelerating supply of a fiat legal tender in regards to its GDP undermines its value and stability. The more paper money that is circulated, the fewer goods and services, may be purchased for the same nominal amounts.

It is necessary to understand that often the effects of printing money are not the same as the intended consequences. Central banks and governments frequently attempt artificially to jolt a slumping economy by injecting it with newly printed cash.

If the economy reacts, and subsequently grows, they try to retrieve much of that cash to remove it from the economy. This is rarely successful and causes the money supply to grow as it is difficult to get it back once it is out in circulation. The effects of economics are always systemic and rarely respond to the intentions of artificial stimulations.

Although it is common to refer to inflation as the printing of money, the literal growth of the money supply occurs more subtly. In America, the Federal Reserve Bank, America’s central bank uses a method called open market operations.

The Federal Reserve control inflation by open markets operations.

This occurs when they buy bonds on the open market, which transfers money from the vaults of the Federal Reserve into the commercial banks which in turn lend it out. This is only a virtual representation as no physical money exists in a real vault. They do this by creating accounts and crediting them with whatever amount they determine.

The Federal Reserve control inflation by influencing interest rates.

In addition to open market operations, some central banks set the interest rates artificially low, which allow businesses to borrow money below market rates, which then accelerates the velocity of the newly circulated money.

When they decide to take the back from the economy, they sell bonds back into the economy and then place the money in the Federal Reserve Bank so that it cannot circulate. This is a tenuous process, and there is much leakage, and the effects of this perpetual practice have taken a toll on the American dollar of which all other currencies are compared.

Want to learn more about inflation? Then check out Inflation, a Free Course on Inflation.

By Alexandre Laurent

Alexandre Laurentl is working in the jewelry and investment gold since 2002. Alexandre graduated from The Normandy School of Business and from the University of Perpignan a Bachelor of economics in 1995.

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