Everybody has felt the impact of inflation. Inflation refers to rising price levels over a certain period of time usually over a year. Inflation negatively impacts economic activity as higher costs reduce purchasing power. There are four main types of inflation with differing impacts on the broader economy.
Demand pull inflation
This type of inflation is directly tied to supply and demand. If goods are scare prices increase. As more supplies enter the market prices will drop. Rapidly growing economies commonly see this type of inflation. The reason is that the economy is growing too fast for supplies to catch up with demand. Means of getting raw material into the market also tends to be diminished in developing economies due to the lack of sufficient infrastructure.
This type of inflation is the result of increased cost to produce a good or service. For example if taxes were to rise on a business it would make them less profitable. As a result they might turn to raising cost on goods to offset these increases. Payroll, supplies, and transportation costs such as fuel cost will all have the same impact. Basically anything that makes it more costly to do business is passed on in the form of higher prices to the consumer.
Pricing power inflation is the result of a business raising prices on goods or services. This is not a result to market conditions as much as it is trying to maximize profit. In order to increase profits businesses have a couple of choices cut costs or raise prices. It is very unlikely this type of inflation would be seen in a time of depressed economic activity like a recession.
Sometimes one sector of the economy will suffer price increases due to supply costs. If the price of aluminum were to rise for example any product made from aluminum would rise as well. Oil also has such an impact. OPEC limiting production, major supply disruptions, and unrest in oil producing regions has all caused oil prices to spike impacting prices of everything dependent on oil.
Federal Reserve policy makers strive to keep inflation in check. The biggest weapon that the fed has at its disposal to control inflation are interest rates. If the economy is growing too fast prices will increase leading to increased inflation. To cool rapid rising economy interest rates will be raised making it more expensive to borrow money. This takes money out of the system slowing economic growth. The more money that is in the system the higher the inflation is. Basically inflation means that currency is losing value. A stronger dollar increases purchasing power thus driving inflation down. A weak dollar means more is needed to buy the same goods driving inflation. If inflation gets out of control it could destroy the entire monetary system. Rampant inflation that is out of control is called hyperinflation and Germany during the 1920’s is a perfect example of the devastation on an economy that hyperinflation causes.