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

Although the many forces affecting inflation can be fairly complex, at a higher level, a few main drivers emerge. Inflation can affect the price you pay for a gallon of milk and the price you pay for a share of common stock. It is important to understand what causes high inflation because it can pose a powerful threat to your journey to financial independence. In extreme cases, it can keep you from retiring in comfort and even affect your ability to meet your day-to-day living expenses.

Demand, Supply, and Inflation

In most cases, and in most countries at most times, two primary drivers of a high rate of inflation appear 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. The inflation rate has increased, 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.

Currency as a Driver

Some countries experience higher inflation due to 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 entities such as the Federal Reserve and Treasury Department.

As more dollars chase fewer goods, the nominal value of those goods rises. If a school teacher is suddenly earning $150,000 per year after inflation, she is going to be able to walk into a Mercedes dealer and buy a car. However, Mercedes production is limited because the company can only produce a fixed number of high-quality automobiles each year, and it takes time for production to ramp up to the new levels of demand.

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 afterward.

That means the teachers won't be able to compete with the lawyers even after their nominal income has skyrocketed, and the price of Mercedes cars 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.

Guarding Against a High Rate of Inflation

One of the most important steps a country can take to guard against high inflation is maintaining a stable currency. Mostly, this is accomplished by a country living within its means and keeping its budget balanced, so that the country does not run at a deficit.

Balanced budgets must be balanced over economic cycles and not necessarily on a year-to-year basis, making the prospect more complex. For example, if the economy collapses, you want the government to be able to spur demand and ease peoples' financial suffering by running deficits designed to kickstart spending. On the other hand, when times are good, you want the government to pay down the money they previously borrowed, allowing the prosperity of the time to pay for the tab that was accrued when things were much bleaker.