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What Causes a High Rate of Inflation?

Understanding the Driving Force Behind High Inflation Rates


Causes of Inflation Rate

There are two major causes for a high rate of inflation. These are an increase in the demand for a good relative to the supply and an increase in the total money supply, leading to more money chasing the same goods. This is important for your portfolio.

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After I explained how the rate of inflation matters to your portfolio and three ways you can protect your investment portfolio from high inflation rates, many of you asked, "What causes a high rate of inflation?".

That is a great question. It is important that you, as a new investor, understand what causes high inflation because inflation can pose a powerful threat to your financial goals. In extreme cases, it can keep you from retiring in comfort and even meeting your day-to-day living expenses.

The Two Primary Causes of a High Inflation Rate

In most cases, there are two primary drivers of a high rate of inflation in a nation's economy. These are:

  • Inflation Rate Cause #1: An increase in demand for goods relative to supply. When more people fight over fewer goods, the price increases. It is just as true for an entire country as it is for a lamp on eBay. We have seen an increase int he inflation rate, in part, because countries like China and India, which had virtually no industrial base a few generations ago, have billions of citizens poised to enter the middle class in the coming years. That means that the fixed, small supply of global copper, silver, gold, and other commodities will be bidded upon by a much larger group of potential buyers, driving up prices. In the past, a handful of industrialized nations, such as the United States, Canada, Australia, Great Britain, Germany, France, Italy, Russia, etc. were the only ones in the game when it came to requiring oil or other commodities. That time has passed.
  • Inflation Rate Cause #2: An decrease in the value of each existing nominal unit of currency. Don't panic - it isn't nearly as complicated as it sounds. It's another way to say a government is printing money. If governments print money and depreciate their own currency, each dollar will buy fewer goods because dollars are less scarce. Think about it. If a school teacher is suddenly earning $150,000 per year, she is going to be able to walk into a Maseratti dealer and buy a car. But Maseratti production is limited - the company can only churn out a fixed number of high-quality automobiles each year. As more money floods the economy, the relative income of different professions isn't likely to change, so lawyers who made $100,000 before the inflation increase might be making $300,000. That means the teachers won't be able to compete with the lawyers - still - and the price of Maserattis will double or triple. That is, the numbers on price tags changes but the relative purchasing power of the individual citizens hasn't changed. The teacher won't be able to afford the car but the lawyer will. The people who get hurt are those who have large bond investments and other fixed incomes such as Social Security.

In a perfect storm of economic disaster, a nation might confront both of these items at the same time and in a meaningful way. This would lead to so-called hyperinflation, which is inflation on steroids. In the great inflation Germany experienced after the first world war, there are stories of wives meeting husbands at factory gates during lunch breaks to get paychecks so they could go spend the money before it became worthless later that day.

The most important steps a civilization can take to guard against a high rate of inflation is to maintain a stable currency. Mostly, this is accomplished by running balanced budgets and avoiding significant deficits. Unfortunately, if a nation finds itself in a situation where it is facing massive deflation risk due to an asset bubble popping, which just means prices were driven up because people took advantage of low interest rates to buy stuff and drive up the market price of homes, cars, jewelry, and art, the only way to avoid a Great Depression is to purposely print money and depreciate the currency.

This gets into an advanced economic concept known as the M1, M2, and M3 money supply. For those of you who are interested, I wrote about it in Why Aren't We Seeing Inflation, Yet?. This article might be too advanced for absolute beginners but it is there for those of you who want to take on the challenge of understanding why we haven't seen prices increase (as of January 2011) despite the Federal government spending trillions of dollars it does not have.

More Information About Inflation and the Inflation Rate

To learn more, read The New Investor's Guide to Inflation and the Inflation Rate, a special that answers questions such as:

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