In 1980 in the United States – just over 30 years ago – a new home in this country cost an

average of $76,000, and the median income was $17,710 per year. Compare that to 2011, when
even after the recent recession, the median home price stood at $139,000, and median household
income was $50,233 per year according to the US Census Bureau.

Why the vast difference in prices? One word: Inflation. Like aging or weight gain, the effects of
inflation are both gradual and profound. Inflation creeps up on us over time, and as we continue
our normal spending and consumption habits, the almost imperceptible increase of consumer
prices doesn’t seem to make a huge difference in our day to day finances – which means it is all
too often vastly underestimated.

But the effects of inflation are huge. And it doesn’t just affect areas like our salaries and the cost
of purchasing a new home. Inflation hits us from every angle. Food prices go up, transportation
prices increase, gas prices rise, and the cost of various other goods and services skyrocket over
time. All of these factors make it absolutely essential that you account for the huge impacts that
inflation can have on your long-term savings and ability to fund your golden years of retirement.

How can you do that? Let’s first get an understanding of what inflation is and the general causes
of it. We’ll then discuss how inflation can impact your investing strategy and style in order to
make thoughtful and conservative long-term financial decisions.

What Is Inflation?

To put it simply, inflation is the long term rise in the prices of goods and services caused by the
devaluation of currency. While there are advantages to inflation which I will discuss later in this
article, I want to first focus on some of the negative aspects of inflation.

Inflationary problems arise when we experience unexpected inflation which is not adequately
matched by a rise in people’s incomes. If incomes do not increase along with the prices of goods,
everyone’s purchasing power has been effectively reduced, which can in turn lead to a slowing
or stagnant economy. Moreover, excessive inflation can also wreak havoc on retirement
savings as it reduces the purchasing power of the money that savers and investors have
squirreled away.
Causes of Inflation

So what exactly causes inflation in an economy? There is not a single, agreed-upon answer, but
there are a variety of theories, all of which play some role in inflation:

1. The Money Supply

Inflation is primarily caused by an increase in the money supply that outpaces economic growth.

Ever since industrialized nations moved away from the gold standard during the past century, the
value of money is determined by the amount of currency that is in circulation and the public’s
perception of the value of that money. When the Federal Reserve decides to put more money into
circulation at a rate higher than the economy’s growth rate, the value of money can fall because
of the changing public perception of the value of the underlying currency. As a result, this
devaluation will force prices to rise due to the fact that each unit of currency is now worth less.

One way of looking at the money supply effect on inflation is the same way collectors value
items. The rarer a specific item is, the more valuable it must be. The same logic works for
currency; the less currency there is in the money supply, the more valuable that currency will be.
When a government decides to print new currency, they essentially water down the value of the
money already in circulation. A more macroeconomic way of looking at the negative effects of
an increased money supply is that there will be more dollars chasing the same amount of goods
in an economy, which will inevitably lead to increased demand and therefore higher prices.

2. The National Debt

We all know that high national debt in the U.S. is a bad thing, but did you know that it can
actually drive inflation to higher levels over time? The reason for this is that as a country’s debt
increases, the government has two options: they can either raise taxes or print more money to
pay off the debt.

A rise in taxes will cause businesses to react by raising their prices to offset the increased
corporate tax rate. Alternatively, should the government choose the latter option, printing more
money will lead directly to an increase in the money supply, which will in turn lead to the
devaluation of the currency and increased prices (as discussed above).

3. Demand-Pull Effect

The demand-pull effect states that as wages increase within an economic system (often the case
in a growing economy with low unemployment), people will have more money to spend on
consumer goods. This increase in liquidity and demand for consumer goods results in an increase
in demand for products. As a result of the increased demand, companies will raise prices to the
level the consumer will bear in order to balance supply and demand. Demand-pull inflation is the
most common. It's simply when demand for a good or service increases so much that it outstrips
supply. If sellers maintain the price, they will sell out. They soon realize now have the luxury of
raising prices, creating inflation.

An example would be a huge increase in consumer demand for a product or service that the
public determines to be cheap. For instance, when hourly wages increase, many people may
determine to undertake home improvement projects. This increased demand for home
improvement goods and services will result in price increases by house-painters, electricians, and
other general contractors in order to offset the increased demand. This will in turn drive up prices
across the board.

Demand-pull inflation occurs when the price level is pulled up by an excess demand. Aggregate
demand for a country’s products can increase due to higher consumption, higher investment,
higher government expenditure or higher net exports. Such an increase in aggregate demand will
not necessarily cause inflation, if aggregate supply can extend to match it.

When the economy has plenty of spare capacity, with unemployed workers and unused
machines, higher aggregate demand will result in higher output but no increase in the price level.
If, however, the economy is experiencing a shortage of some resources, for example – skilled
workers, then aggregate supply may not be able to rise in line with aggregate demand and in-
flation occurs. In a situation of full employment of resources it would not be possible to produce
any more output. As a result, any rise in demand will be purely inflationary.
4. Cost-Push Effect

Another factor in driving up prices of consumer goods and services is explained by an economic
theory known as the cost-push effect. Essentially, this theory states that when companies are
faced with increased input costs like raw goods and materials or wages, they will preserve their
profitability by passing this increased cost of production onto the consumer in the form of higher
prices.

A simple example would be an increase in milk prices, which would undoubtedly drive up the
price of a cappuccino at your local Starbucks since each cup of coffee is now more expensive for
Starbucks to make.

Cost-push inflation occurs when the price level is pushed up by increases in the costs of
production. If firms face higher costs, they will usually raise their prices to maintain their profit
margins. There are a number of reasons for an increase in costs.

One is wages increasing more than labour productivity. This will increase labour costs. As labour
costs form the highest proportion of total costs in many firms, such a rise can have a significant
impact on the price level. It will also not be a one-off increase. The initial rise in the price level is
likely to cause workers to press for even higher wages, leading to a wage-price spiral.

Another important reason is increase in the cost of raw materials. Some raw materials, most
notably oil, can change the price by large amounts. Other causes of cost-push inflation are
increases in indirect taxes, higher cost of capital goods and increase in profit margins by firms.

Cost-push inflation can be illustrated on an aggregate demand and aggregate supply diagram.
Higher costs of production shift the AS curve to the left and this movement forces up the price
level.

5. Exchange Rates

Inflation can be made worse by our increasing exposure to foreign marketplaces. In America, we
function on a basis of the value of the dollar. On a day-to-day basis, we as consumers may not
care what the exchange rates between our foreign trade partners are, but in an increasingly global
economy, exchange rates are one of the most important factors in determining our rate of
inflation.
When the exchange rate suffers such that the U.S. currency has become less valuable relative to
foreign currency, this makes foreign commodities and goods more expensive to American
consumers while simultaneously making U.S. goods, services, and exports cheaper to consumers
overseas.

This exchange rate differential between our economy and that of our trade partners can stimulate
the sales and profitability of American corporations by increasing their profitability and
competitiveness in overseas markets. But it also has the simultaneous effect of making imported
goods (which make up the majority of consumer products in America), more expensive to
consumers in the United States.

6. Market Power
First, the economic agent could have market power. This means they have the ability to avoid
(at least to some extent) competitive pressures. It is the latter that forces firms to please
consumers. Adam Smith wrote in 1776 that we cannot trust the undertakers of business to look
out for anyone but themselves, and so we must handcuff them. But not with markets, per se, with
competition, and the two do not always go hand in hand. The OPEC oil cartel in the 1970s and
1980s is a classic example of marker power. Had there been other viable sources of what they
sold, they could not have restricted supply and driven up prices as they did because the
competition would not have allowed them to do so. We would have just bought oil (or a close
substitute) from someone else. Up to late 1973, they lacked the political will to set strict quotas
among the various exporters. But, once the motivation was provided by US involvement in the
Yom Kippur War, they made a conscious decision to raise prices by cutting supply. And because
they were able to avoid competition, it worked! Even though households do not buy barrels of
oil, it caused terrible inflation. It drove up the prices of anything that used petroleum or
petroleum-based products, it raised the price of gas and, therefore, anything that needed to be
transported, and it caused inflation in other energy sources as users shifted to those products.
Market power–not money growth–caused this inflation. The money supply only rose as a result
of the fact that firms and consumers took out larger loans and sold assets for cash. The Federal
Reserve acted as it should have done in these circumstances, accommodating this increased
demand.
(Note that having market power does not give carte blanche to raising prices. Even monopolists
can only charge so much before consumers stop buying their products. However, they have the
incentive and ability to engage in periodic attempts to capture more income for themselves. I
won’t go into the specifics of when and how they do so here, but this phenomenon is discussed
in detail in Alfred Eichner’s classic study of the microeconomy, Megacorp and Oligopoly: Micro
Foundations of Macro Dynamics, Cambridge U Press, 1976. Thought it’s a little dated, the basic
lessons still apply.)

The impact of the inflation of the 1970s and 1980s was hardly even, and this is always the case.
Remember that when you pay more for something, the person on the other side of the register is
also getting more. It depends on individual buying patterns and particularly where you earn your
salary. With the OPEC inflation, those in the oil industry, while facing the same rising prices at
the gas pump, grocery store, etc., as everyone else, were actually better off than they had been
before because their salaries and profits rose at a higher rate. This was especially true of those in
the OPEC countries who controlled the oil supplies. The inflation process redistributed income
towards them–that was the whole point, wasn’t it? This fact is exceedingly important to
understand. Inflation never affects everyone equally. It shifts buying power from one group to
another (even though the winners may still complain because they see themselves as hurt by the
overall price increases–what they don’t understand is their role in causing the latter!). In fact, it is
the very attempt to capture more income that is at the heart of the inflationary process under
these circumstances. Money supply growth did not cause prices to rise, OPEC’s attempt to grab a
larger income share did. No amount of controlling the money supply was going to eliminate the
ultimate impact of rising oil prices: the redistribution of income towards those countries and the
oil industry.

As a very quick aside, it’s worth pointing out that just because the market created a particular
price, wage, profit rate, or income does not mean that it is somehow objectively “fair.” These
numbers only quantify our existing social values. There are, of course, more purely economic
forces at work, too. Gold is more valuable than silver because there is less of it. But can we truly
justify the wages and incomes earned by African Americans in the 1950s as economically
reasonable, simply a function of their productivity? The fact of the matter is that a free-market
system in a racist society reflects and reinforces racist values. Markets are people, and the
preferences of those people, for good or bad, end up in the prices we see. My point here is that
there may be times when we would, as a nation, actually prefer to alter the outcomes created by
competitive pressures. Desegregation interfered with the market mechanism and the forces of
competition, as did movements aimed at creating safer workplaces. Furthermore, paying African
Americans more and reducing the chances of on-the-job injuries caused inflation (because they
raised costs) and redistributed income. Was this justifiable or not? Unfortunately, these are not
simple questions.

Other references:

http://www.yourarticlelibrary.com/macro-economics/inflation-macro-economics/main-causes-of-
inflation-derived-by-economists/32883/

http://useconomy.about.com/od/inflationfaq/f/Causes-Of-Inflation.htm

HOW TO CONTROL INFLATION (MEASURES)

Use the following links:

http://www.yourarticlelibrary.com/macro-economics/inflation-macro-economics/how-to-control-
inflation-4-measures-explained/37969/

http://www.yourarticlelibrary.com/macro-economics/inflation-macro-economics/controlling-
inflation-3-important-measures-to-control-inflation/31093/

http://www.economicshelp.org/blog/2269/economics/ways-to-reduce-inflation/