What Causes Inflation?

Inflation impacts all our lives, but most people don’t even know where it comes from or what drives it. They just know inflation is the bad guy, and they hate it because it makes groceries cost way more than they used to. Even though we can’t change the inflation rate, we can learn more about what’s causing inflation and how to tweak our money habits to combat it. So step into our time machine as we go back to that part of Economics 101 you snoozed through.

What Causes Inflation?

A lot of behind-the-scenes stuff can kick-start inflation. And most of the time, it’s a combination of those things that ignites the fire and gets inflation to start heating up. Here are a few of the common causes of inflation:

Demand-Pull Inflation

If you really want to know what causes inflation, a big part of it goes back to demand-pull inflation. In other words, the demand for goods and services pulls up prices when the supply of those goods and services stays the same. Here’s a simple example of how that works: Say a farmer has 10 apples that he’s selling for $1 each. If 10 people want to buy apples, then everyone pays their dollar and starts chomping. But if 12 or 15 people want apples, that means demand is higher than supply. The farmer will then raise his prices. Demand-pull inflation happens when the demand for goods increases across the whole economy. If sellers can’t keep up with the demand, then they raise their prices.

Cost-Push Inflation

When the cost of the stuff manufacturers use to make goods rises, that causes cost-push inflation. When this happens, prices are pushed up (usually by something cutting off the supply of resources). Think back to when the global supply chain took a hit at the beginning of COVID-19, when the Suez Canal was blocked, and when the Colonial Pipeline was hacked. Sure, a lot of that was caused by people panic-buying, but it was still a shortage of resources that pushed prices up. And because oil is such a big part of the global economy—from transportation to plastics—an increase in oil prices often causes cost-push inflation.

Increased Money Supply

At first, you might think having more money to go around would be a good thing. And yeah, that would be true if it were all in your own wallet. But if everyone has extra money to spend because the government handed out stimulus checks (sound familiar?), that increased money supply can cause inflation to rise. Economists refer to this situation as too many dollars chasing too few goods.

Devalued Dollar

When the rate that the dollar can be exchanged for goods drops, products imported from other countries become more expensive to buy. And you guessed it—that means the cost of those goods goes way up. In other words, a devalued dollar means that the dollar has less purchasing power than it did—so you pay more to get the same stuff.

What Is Inflation?

Okay, maybe you’re still wondering what inflation really is in the most basic of terms. So before we dig in more, let’s cover that: Inflation happens when prices go up and your dollar’s purchasing power (the value of money) goes down as time marches on. Basically, inflation makes prices shoot up and everything cost more.

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In the last few years, we’ve seen lightning-fast inflation on things like groceries and homes. But it wasn’t always like this. The Federal Reserve likes to keep inflation around 2% (if they can help it).¹ The Fed tries to keep inflation in check by raising interest rates, and that’s why it raised rates for the last couple of years—and only recently started cutting them as inflation got closer to 2%.

How Does Inflation Work?

So, we know inflation happens when the prices of goods go up. But what causes the prices of things to go up anyway? It all goes back to supply and demand. When people want to buy things but there aren’t enough products for them to buy, the prices go up to meet the demand.

But what’s the deal here? Why can’t a dollar today buy you as much as it did in 1955? Step into our economics class and we’ll try to walk you through it (without putting you to sleep).

Basically, that steady 2% inflation rate makes the value of that $20 bill in your pocket drop over time. Remember how your grandparents talked about how they could buy candy for a nickel and go see a movie for under $1? Must’ve been nice for them! Inflation is the reason we don’t pay the same prices for those things today.

What Has Caused Inflation the Last Few Years?

Oh, boy—where do we even begin? Inflation took off after the economy bounced back from the pandemic. People left their houses (finally) armed with multiple stimulus checks burning a hole in their pockets. Post-pandemic folks were ready to spend, spend, spend. And all that money started swirling around the economy and kicked inflation into high gear.

That extra money, combined with shortage after shortage and supply chain issue after supply chain issue, made inflation even worse. Basically, there were too few goods to go around.

Because of the shortages and supply chain problems, it cost businesses more money to produce all the items people wanted. And companies passed the bill right on to the consumer—sometimes even shrinking the product (but never the price tag). And guess what? People just kept on paying the higher prices.

How Is Inflation Measured?

Great question! Meet the Consumer Price Index. The CPI measures the average price of goods and services over time. It’s calculated by the U.S. Bureau of Labor Statistics (BLS) and is used to keep track of the prices of everyday expenses—things like gas, food and rent.

The August 2024 numbers show that inflation’s sitting at 2.5% over the previous 12 months.² That’s a welcome relief from the 8% we saw two years ago!³ And thanks to the Consumer Price Index, we’re able to see the way inflation changes from month to month.

Even though the Consumer Price Index won’t tell you what causes inflation, it can tell you a lot of other info—like the rise and fall of inflation rates and how much prices jump on specific items like groceries. Want to know how much a carton of eggs costs this year compared to last year? The CPI will tell you all you need to know (and then make you want to invest in some chickens).

What Can I Do About Inflation?

Okay, now that we’ve covered all that, this is a good time to take a big, deep breath. Because the truth is, inflation happens. And even though it’s super annoying (and gets more annoying by the month), there’s no reason to lose your hope here. You won’t find that as a headline running on the nightly news. Shocker, we know.

If you really want to combat inflation, here are four ways to go to battle:

1. Spend less.

Okay, we know that’s easier said than done. But with inflation kicking into high gear, it’s more important than ever to try to cut costs where you can. Ditch the impulse buys, skip eating out, and cancel some subscriptions. Making just a few tweaks to what you spend each month can go a long way.

2. Invest your money.

Investing is a great way to combat inflation because you’re stashing away your money and letting it grow at an annual rate that should beat the rate of inflation.

In other words, if you stick $500 under your mattress, it’s going to be worth less next year than it’s worth today. But if you invest that $500 and get an average return of around 10%, you turn that $500 into $550. The value of your money went up instead of down. Pretty amazing concept!

All right, investing is great and all—but remember, this is just for the Baby Step 4 and over crowd. So if you’re still in debt and saving up a fully funded emergency fund, hold off on investing until you’ve knocked that out. And once you have, reach out to a SmartVestor Pro to get all the insight you need about the investing process.

3. Make more money.

Call us old-fashioned, but upping your income is a pretty good way to beat inflation. Maybe that comes from a raise, promotion or switching jobs for a better-paying salary. Or maybe it just means you finally start selling stuff you don’t use on Poshmark, eBay or Facebook Marketplace. Companies are hiring like crazy these days, and it’s a great time to pick up a second job on the weekends or drive for Uber or DoorDash. If you want to make an extra buck, you can totally do it.

4. Budget your money.

Okay, so now you’re making extra cash to kick inflation in the face. Yay, good for you! But now it’s time for the most important part: not spending all the cash you’re bringing in. It’s a little too easy to make more money and then just turn around and spend it. That’s why you need a budget to tell your money where to go each month (especially if you live in a state that’s dishing out inflation stimulus checks).

Making more money to cover high inflation prices won’t do you much good if you don’t make a plan for it. Our simple budgeting tool, EveryDollar, lets you give every dollar a name and take control of where your money goes. So, nice try, inflation. Better luck next time.