What is Inflation?

what is inflation, all about inflation

Estimated reading time: 5 minutes

In a market economy, prices for products and services can fluctuate based on consumer demand, product and service availability, and the costs involved with production, labor, shipping, etc. So, it is not uncommon to see prices for some products and services rise and prices for some products and services fall. When there is a sustained increase in the general price level of products and services in our economy over a period of time, it is a sign of inflation.

Investment analysts, university instructors, politicians, and news anchors all talk about inflation, so there is no shortage of information about the topic. So, what is inflation? This Balboa Capital blog article answers that question and provides information about inflation that you might not be familiar with. You will also learn how inflation can affect small businesses.

Inflation definition.

As mentioned earlier in this blog article, inflation occurs when the price of products (e.g., food, clothing, electronics) and services (e.g., healthcare, insurance, landscaping) increases over time. When this happens, consumers have less buying power which, in turn, results in less spending because the value of the dollar has declined. Let us use a landscape contracting business as an example.

The owner of the landscape contracting business provided a homeowner with an estimate for a new 14-foot by 8-foot backyard patio last year, and the cost for materials and labor combined was $5,000. Realizing the need to spend their discretionary income elsewhere, the homeowner decided to wait ten months to start the patio job. However, inflation has set in, and the cost of materials increased by 30%. So, the original estimate the contracting business owner provided is now $6,500. In other words, the homeowner can get less patio for $5,000 today than they could last year.

What causes inflation?

This is one of the most challenging questions to answer. That is because so many factors can contribute to inflation, and economists and financial experts have varied opinions about what causes inflation. However, they can all agree that increased prices over a specific period can contribute to inflation. However, price increases in a particular sector, say automobiles, do not always indicate overall inflation. For inflation to exist, there need to be price increases and supply-demand concerns on a wide scale. Following are descriptions of the three types of inflation.

Demand-pull inflation

This is a situation where consumers demand more goods than what producers can supply, pushing up the price level. As a result, inflation rises right along with the gross domestic product (GDP), and the number of unemployed workers decreases.

Cost-push inflation

Cost-push inflation occurs when there is an increase in the production costs of goods and services, which leads to a rise in their price levels. Because of this, small businesses need to increase their prices to maximize their profit margins and remain in good financial standing.

Built-in inflation

This type of inflation develops when workers ask their employers for more money when the prices of products and services rise to accommodate the higher cost of living. The one caveat is that higher wages generally lead to even higher prices for products and services.

In addition, other circumstances can contribute to inflation. These include natural disasters (e.g., severe weather events), international conflicts, consumer spending/confidence, and interest rates.

How is inflation measured?

If you watch old movies and television shows, there may be glimpses of what things used to cost. For example, a scene in a 1950’s diner might feature a sign that lists hamburgers for .25 cents and soda pop for .10 cents. Today, you can buy a hamburger at a quick-service restaurant for under $3 and soda pop for $1, so the price for each has increased slowly over five decades. However, if the cost of the same hamburger and soda pop suddenly spiked to $10 and $4, respectively, and prices of other foods, products, and services also increased across the board, that is a sign of inflation.

The inflation rate is the increase or decrease, as a percentage, in product and service prices during a time frame, be it a month, quarter, or a year. So, if the inflation rate is 3% and a cup of coffee costs $1.50. In that example, a cup of coffee will cost $1.55 ($1.50 x 3% = .045). In the United States, inflation is monitored by Federal Reserve policymakers, who keep a watchful eye on several price indexes. These include the consumer price index (CPI) and producer price index (PPI), both of which are overseen and facilitated by the Bureau of Labor Statistics (BLS). It is commonly agreed among financial experts and the Federal Reserve that moderate inflation of 1.5% to 2% is acceptable and can benefit our country’s economic growth and output.

Impact on small businesses.

The effects of inflation are felt differently by small businesses based on the industry, market situation, and overall brand strength. That being said, as the price of goods increases, manufacturers in all sectors will also raise the cost of producing those goods. This means that small businesses will have to charge more for their products, reducing demand from consumers who are less able or willing to afford them at higher prices. Increasing prices can also lead to additional problems such as losing customers and market share.

A higher inflation rate can make it more difficult for small businesses to maintain their cash flow and keep up with their overhead costs and operating expenses. In addition, inflation can significantly impact small business borrowing, as the interest rates on loans are often tied to a benchmark interest rate. This means that if inflation is high, so are the interest rates on loans, credit lines, and other types of financing.

On a positive note.

Although inflation can hurt small businesses, it is not always doom and gloom. For starters, when a small business raises its prices, it may lose some customers, but it has a chance of producing good revenues. In short, the higher price points might offset the reduction in sales volume and result in good year-over-year (YOY) earnings. Next, businesses that have accumulated debt before inflation sets in can keep it on the cheap. That is because the value of money decreases during inflation. Finally, some business owners choose to take on new debt at a fixed interest rate before inflation takes off, resulting in much higher borrowing costs.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.