What Causes a High Rate of Inflation?

Understanding the Driving Force Behind High Inflation Rates

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.
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. Arman Zhenikeyev/Getty Images

If you've read how the rate of inflation matters to your portfolio and three ways you can protect your investment portfolio from high inflation rates, and you find yourself asking, "What causes a high rate of inflation?", you've come to the right place.

That is a great question, and one that is often asked by investors and non-investors alike. Inflation can effect the price you pay for a gallon of milk and the price you pay for a share of common stock.

It is important that you, as a new investor, understand what causes high inflation because inflation can pose a powerful threat to your journey into financial independence. 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, and in most countries at most times, there are two primary drivers of a high rate of inflation in a nation's economy.

First, high inflation can be caused by 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 car on eBay. We have seen an increase in the 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 bid 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. This also means that those commodities will come to rely on demand from those countries so a slow down could have widespread consequences.

Second, higher inflation can be caused by a decrease in the value of each existing nominal unit of currency. This is sometimes caused by a government promising more benefits than it can deliver and increasing the money supply, or "printing money" (though, these days, it's almost entirely electronic debits and credits) through the various operations and activities of the Federal Reserve and Treasury Department. As more dollars chase fewer goods, the nominal value of those goods rises; an all-to-familiar concept you know on an instinctual level. If a school teacher is suddenly earning $150,000 per year after inflation, she is going to be able to walk into a Maserati dealer and buy a car. However, Maserati production is limited because the company can only produce 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 after.

That means the teachers won't be able to compete with the lawyers even after their nominal income has skyrocketed, and the price of Maseratis doubles or triples, putting them out of reach for the teachers once more. That is, the numbers on price tags changes but the relative purchasing power of the individual citizens remains the same. 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 that don't have some sort of inflation protection.

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 a monetary phenomenon known as hyperinflation, which is inflation on steroids. In the great inflation Germany experienced after World War I, 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.

People wallpapered their homes with currency because it had more utility for its decorative beauty than as a means of exchanging goods and services.

How a Country Can Guard Against a High Rate of Inflation

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 living within its means and running what are known as balanced budgets. The thing is, the balanced budgets must be balanced over economic cycles and not necessarily on a year-to-year basis. For example, if the economy collapses, you want the government to be able to spur demand and ease the suffering by running deficits designed to kickstart spending. On the other hand, when times are good, you want them paying down the money they previously borrowed, allowing the prosperity of the time to pay for the tab that was accrued when things were much more bleak.

To go further down this rabbit hole would require getting into a discussion of more advanced economic concepts 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?. I wouldn't recommend it 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 doesn't have to get us out of the catastrophe that was the Great Recession of 2008-2009.

More About Inflation and the Inflation Rate

To learn more about inflation and guarding against high rates of inflation, read The New Investor's Guide to Inflation and the Inflation Rate. It is a special that I put together with articles that answer questions such as: