How Inflation Works

Prices don't just rise on their own, so what are the underlying forces that slowly erode the buying power of the dollar or any other currency?

The most common explanation for inflation is based on the free market principle of supply and demand. In a free and open market, if the demand for a product is greater than the supply, the price of that product tends to go up. If supply is greater than demand, then prices go down. To put it another way, when there's too much product on the market, each unit loses value.

The same principle is true for money. If there is too much money in circulation — both cash and credit — then the value of each individual dollar decreases. This explanation of inflation is called the demand-pull theory and is classically defined as "too much money chasing too few goods."

But how can there be too much money in circulation? For that answer, you need to understand how the Fed works. The Fed, formally known as the Federal Reserve, is the "bank of the banks," and the gatekeeper of the U.S. money supply. The Fed uses its monetary policy to influence the amount of money held in banks and the interest rates at which that money is lent to people and businesses. We'll talk more about monetary policy in a few pages.

The second explanation for the cause of inflation is the cost-push theory, which states that increases in the costs of raw materials and labor drives up the prices of goods and services. Bread is a good example. When the price of wheat goes up, the price of flour goes up, which makes the cost of bread rise (pun intended).

But do increases in the price of individual products really cause inflation? Many economists say no. For example, demand for bread increases but the baker does not immediately increase his prices. Instead he depletes his stock of flour first. If increased demand continues, he'll buy more flour from his supplier, who will in turn buy more wheat from his farmer. Imagine that his fellow bakers are experiencing similar demand. Since all the suppliers want more flour, they'll offer the farmer more money for his wheat, which will cause the price to go up on wheat, flour, and eventually, on bread. So even though it seems like the higher cost of raw materials is responsible for the higher cost of the final item, it was actually the aggregate demand for the final product that caused the price to go up [source: Batten].

Changes in the relative prices of individual products do not mean inflation has taken place. Inflation is defined as a "persistent" rise in the overall level of prices of all goods and services [source: Batten]. So, even a serious spike in gasoline prices — as experienced during the OPEC embargo of the 1970s — isn't the root cause of inflation.

Economist Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomenon," meaning that money supply, not the rising cost of doing business, is the primary cause of inflation.