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Peter DeCaprio: What are the five factors that contribute to inflation, and how do they affect a country’s business cycle?

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The five factors that contribute to inflation do not affect the business cycle. The five factors are:

1) Increases or decreases in spending by consumers,

2) Increases or decreases in spending by businesses,

3) Volume of money being spent,

4) Volume of money available to be spent, and

5) Expectations of future prices.

Each factor affects inflation differently based on changes in velocity (the speed at which money moves through the economy). For example, an increase in business spending will cause inflation only if there is more money in the system for consumers to spend. If the amount of money were held constant while there was an increase in businesses’ expenditures, no inflation would result. As another example, if there was inflation, but there were no expectations of future prices changing, it would decrease spending as people waited for prices to decline. Only the fifth factor affects the business cycle by increasing or decreasing aggregate demand and real GDP.

As per Peter DeCaprio, inflation is a general increase in the price level, i.e., when all categories of goods and services go up in price. Inflation should not be confused with cost-push inflation (also called supply shock inflation), which is an increase that occurs due to increases in the cost of production, such as raw materials and labor (see: What Causes Supply Shock Inflation?).

Unemployment Rate –

Unemployment rate, employment rate, and other labor market indicators explained.

Business Cycle –

The five factors that contribute to inflation do not affect the business cycle.

Velocity –

Velocity is just one factor in evaluating an economy’s strength. It also should not be confused with money velocity, which refers to how often currency changes hands within the economy (see: Money Velocity).

Aggregate Demand –

Aggregate demand measures the total of all goods and services sold in an economy over time. It’s used primarily by governments to chart national economic performance.

Real GDP –

Real gross domestic product accounts for price appreciation or depreciation, reflecting the true value added by each sector of the economy.

Supply Shock Inflation –

Supply shock inflation is an increase that occurs due to increases in the cost of production, such as raw materials and labor.

Price Index –

Price indexes are used primarily by central banks to measure inflation. They include a basket of representative goods rather than measuring just one good, making them more accurate.

Details:

1 . Increases or decreases in spending by the consumer.

If there is no increase over time, there won’t be any reason for prices to increase. This factor will have little effect on inflation unless there are changes in velocity, which can cause this factor to have a greater effect on aggregate demand.

2 . Increases or decreases in spending by businesses.

If no money is created to expect it to be spent (i.e., velocity is constant), then there won’t be any reason for prices to increase. Also, an increase in spending only causes inflation if spending increases over time. This factor will have little effect on inflation unless there are changes in velocity, which can cause this factor to have a greater effect on aggregate demand.

3 . The volume of money being spent.

If the number of money decreases and people expects prices to fall, then it’s possible that people will not buy as much, causing deflation (i.e., falling prices). So, except for expectations, this factor will not directly contribute to inflation or deflation. Still, velocity could make this factor contribute more greatly, e.g., less purchasing leading to lower prices and higher purchasing leading to higher prices.

4 . Changes in the price of inputs.

Although an increase or decrease in input costs, such as raw materials and labor, will cause businesses to change prices, inflation will only result if there is more money available for consumers to spend because higher input costs, without increased consumer spending, could lead to deflation instead.

5 . Expectations about future prices.

If people expect prices to increase, they are more likely to spend now before prices go up. Because this factor is the only one that directly affects aggregate demand, it is the only factor that can contribute to inflationary pressure by increasing aggregate demand. It is also why things like “price wars” have little effect on actual selling prices – they encourage consumers to buy sooner rather than later to take advantage of the lower prices.

Conclusion by Peter DeCaprio:

The factors contributing to inflation are driven by – or are consequences of – changes in aggregate demand, the total of all goods and services sold in an economy over time. The five factors that affect aggregate demand are consumer spending, business spending, velocity, input costs, and expectations.

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