Understanding the different types of inflation

Remember when you would hear your elders talk about going to the movies for a quarter? If you've been experiencing sticker shock from food prices at the grocery store lately (and who hasn't?), you might do some reminiscing of your own about days when you went to the movies for a mere 5 bucks. All thanks to that pesky little part of economics called inflation.

Inflation is the rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of money over time. Inflation affects us all, from the price of groceries to the rapidly rising cost of college tuition for your kids. 

However, there are different types of inflation, and each has its causes and effects. Knowing the difference can help you make better financial decisions.

Three types of inflation: Impact on family finances

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When inflation is high, you might seek out better deals to stretch your paycheck. In a moderate-inflation or high-inflation environment, having a strategy for spending, saving, and investing is especially important to keep inflation from eating away at your purchasing power.

Here are the typical dynamics that explain inflation:

1. Cost-push inflation: Increased cost of production

Picture this: Production costs increase, and businesses pass those costs on to you. Boom, prices rise. This can happen due to higher wages, pricier raw materials, or new taxes. Imagine oil prices shooting up — suddenly, transportation costs soar, and everything from your grocery delivery to your favorite online orders are more expensive.

For a real-world example, look at the grocery store. The COVID-19 pandemic threw a wrench into supply chains, hiking up transportation and labor costs. As a result, many everyday essentials like bread, milk, and vegetables suddenly cost more. This example of cost-push inflation made many of us rethink our shopping lists. 

2. Demand-pull inflation: Demand exceeds supply

Demand-pull inflation kicks in when the economy's booming. When people spend more, but the supply chain can't keep up, prices climb. Think of a booming job market where people tend to have extra spending money — they’re buying more, but businesses may not be able to meet the demand.

When this demand imbalance happens on a large enough scale, it affects aggregate demand, which represents the total spending on goods and services in an economy. This increased demand can push consumer prices up across the board. Conversely, if the total supply of goods and services, known as aggregate supply, is insufficient to meet this demand, it can also contribute to rising prices.

Take the recent housing market frenzy as an example of demand-pull inflation. Low interest rates combined with high demand sent home prices soaring. Everyone was eager to buy, but there weren’t enough houses to go around. The result? Skyrocketing prices that make it harder for families to snag their dream home.

3. Built-in inflation: Increase in prices and wages

Built-in inflation, or wage-price inflation, is a tug-of-war between wages and prices. Workers want higher wages to keep up with living costs, and businesses raise prices to cover these wage hikes. It’s a cycle where each one fuels the other, pushing both wages and prices higher and higher.

Look at the tech industry: As living costs rise, tech companies often bump up salaries to attract and keep top talent. Those same companies may raise prices on their products and services to balance the higher wages. Suddenly, your devices and subscriptions cost more.

Additional factors contributing to inflation

1. Government policy: All sorts of government decisions affect the economy, but increased money supply controlled by the Federal Reserve often has the most direct effect on inflation. The Fed sets the federal funds rate, which basically determines how cheap or expensive it is for businesses and people to borrow money – aka interest rates. When the Fed lowers interest rates, borrowing becomes less expensive, encouraging spending and investment. But lower rates also tend to increase the amount of money circulating in the economy. This can lead to more dollars chasing the same goods and services, which tends to drive up prices and contribute to inflation.

2. Currency depreciation: Changes in the value of a country's currency can lead to inflation, especially in nations that import a lot of goods. If the value of the money weakens, imported goods become more expensive, which may inflate prices overall. For example, if the U.S. dollar is weaker than the Euro, suddenly, Italian olive oil or European-made appliances aren't such a steal anymore. This shift means you’d end up getting less bang for your buck, making those European imports even more of a luxury for American shoppers.

3. Greedflation: Inflation isn’t always due to economic factors. Sometimes, businesses raise their prices to boost revenue and profit.

Tips to protect your finances from inflation

With the right strategies, you can protect your purchasing power and even come out ahead. Being prepared is a better strategy than just wishing and wondering when inflation will go down. Here's how you can stretch your hard-earned money further:

• Diversify like a pro: One way to help mitigate the impact of inflation is by diversifying your investments. Spread your money across assets that typically outpace inflation, like certain stocks, real estate, or inflation-protected securities.

• Stay on top of your budget: Inflation can sneak up on you, with subtle cost increases that add up over time. Regularly review and adjust your budget to stay ahead of the game. Look at where your money is going and where you can cut costs or find better deals. Whether it's renegotiating service contracts, cutting unnecessary expenses, or earning interest with a high-yield savings account, being proactive can help you stay on solid financial footing.

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With the right knowledge, you can make decisions that keep you and your family in a favorable position, no matter which type of inflation the economy brings. Greenlight's Learning Center turns financial education into an investment in yourself. You’ll find everything from family budgeting basics to fun facts and trivia. Greenlight delivers the tips, tricks, and info you need to make smart money moves.