Inflation is when prices keep rising. (For more about inflation, see Inflation FAQS)The
most common cause of inflation is when demand outstrips supply. This
happened in housing in 2005-2006. There were so many investors looking
to buy houses, it drove housing prices up to record-high levels. This is
known as demand-pull inflation. By the way, when inflation only hits one asset category, it is known as asset inflation.
The Fed didn't take steps to stop inflation because it was restricted
to housing, and hadn't spread into other areas of the economy.
Another cause of inflation is when there is a shortage of supply, such as the 1970s oil embargo. OPEC restricted oil in 1973, quadrupling prices. This is called cost-push inflation.
A third cause of inflation is an over-expansion of the money supply. The money supply is not just cash, but also credit, loans and mortgages. When loans are cheap, then there will be too much money chasing too few goods, creating inflation. This is what really created the inflation in housing prices in 2005-2006. Deregulation allowed banks to push mortgages onto everyone. When people could borrow for virtually nothing, and needed no money down, it made no sense to rent. With low interest rates, homeowners used their homes as an ATM machine, spending their equity on TVs, cars...and more houses. However, inflation was restricted to housing prices. The price of everything else was subdued, since China kept its currency, the yuan, pegged below the dollar. This artificially made prices of their exports to the U.S. low.
In addition, China's lower wages meant wages couldn't rise in the U.S. This also kept wage inflation low. This is when wage earners have the power to force through wage increases, which companies then pass through to consumers in higher prices. Thanks to China and the decline of union power in the U.S., this has not been a driver of inflation for many years.
A fifth cause of inflation is expectation of inflation. This was pointed out by Federal Reserve Chairman Ben Bernanke. He said that, once people expect inflation, they will buy things now before prices go up further in the future. This increases demand, which then created demand-pull inflation. Once expectation of inflation sets in, it is very difficult to eradicate. That's why the Fed's most important mandate is to fight inflation. Bernanke is the first U.S. Fed chairman to set an inflation target to make sure the market knows he won't let inflation rise. The inflation target is based on the core inflation rate, which eliminates volatile food and energy costs. A healthy economy can sustain a core inflation rate of 2%, which is Bernanke's target.
A sixth cause of inflation is the declining value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. That's why the Chinese peg their currency to always be lower than the dollar, which has been declining since 2002. (Article updated January 26, 2011)
ADOPTED FROM ABOUT.COM
Another cause of inflation is when there is a shortage of supply, such as the 1970s oil embargo. OPEC restricted oil in 1973, quadrupling prices. This is called cost-push inflation.
A third cause of inflation is an over-expansion of the money supply. The money supply is not just cash, but also credit, loans and mortgages. When loans are cheap, then there will be too much money chasing too few goods, creating inflation. This is what really created the inflation in housing prices in 2005-2006. Deregulation allowed banks to push mortgages onto everyone. When people could borrow for virtually nothing, and needed no money down, it made no sense to rent. With low interest rates, homeowners used their homes as an ATM machine, spending their equity on TVs, cars...and more houses. However, inflation was restricted to housing prices. The price of everything else was subdued, since China kept its currency, the yuan, pegged below the dollar. This artificially made prices of their exports to the U.S. low.
In addition, China's lower wages meant wages couldn't rise in the U.S. This also kept wage inflation low. This is when wage earners have the power to force through wage increases, which companies then pass through to consumers in higher prices. Thanks to China and the decline of union power in the U.S., this has not been a driver of inflation for many years.
A fifth cause of inflation is expectation of inflation. This was pointed out by Federal Reserve Chairman Ben Bernanke. He said that, once people expect inflation, they will buy things now before prices go up further in the future. This increases demand, which then created demand-pull inflation. Once expectation of inflation sets in, it is very difficult to eradicate. That's why the Fed's most important mandate is to fight inflation. Bernanke is the first U.S. Fed chairman to set an inflation target to make sure the market knows he won't let inflation rise. The inflation target is based on the core inflation rate, which eliminates volatile food and energy costs. A healthy economy can sustain a core inflation rate of 2%, which is Bernanke's target.
A sixth cause of inflation is the declining value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. That's why the Chinese peg their currency to always be lower than the dollar, which has been declining since 2002. (Article updated January 26, 2011)
ADOPTED FROM ABOUT.COM
