What Is Inflation and How Does It Affect Us?

Your grandmother may have mentioned how much cheaper things were when she was younger, and this is due to inflation. When there are irregularities in the supply and demand of products and services, the result is a rise in prices. While there are benefits to inflation, excessive inflation is not ideal. If your money is worth less tomorrow, why would you bother saving it? To prevent inflation from getting out of hand, governments implement policies that aim to decrease spending.

Basics

The sustained increase in the cost of goods and services in an economy is what we refer to as inflation. It leads to the reduction of the purchasing power of a currency over time. Inflation is a long-term phenomenon that affects nearly all items in the economy, unlike "relative-price change," which only affects one or two goods.

Annual measurements of inflation rates are conducted by most countries, usually expressed as a percentage change in comparison to the previous period.

This article aims to discuss the various causes of inflation, methods used to measure it, and the positive and negative impacts it can have on an economy.

Reasons for Inflation

Inflation is caused by either an excessive supply of currency in circulation or a shortage of supply of a specific high-demand good. For example, when European conquistadors brought gold and silver bullion from the western hemisphere in the 15th century, the sudden influx of supply caused inflation in Europe.

However, there are more nuanced causes of inflation that fall into different categories. Robert J. Gordon's "triangle model" distinguishes three major types of inflation: demand-pull, cost-push, and built-in inflation. While there are other variations, these are the main ones. In demand-pull inflation, the increase in demand for goods and services drives up prices. Cost-push inflation, on the other hand, is caused by an increase in production costs. Built-in inflation happens when inflation expectations influence wage and price-setting decisions.

Demand-Pull Inflation

The most prevalent type of inflation is demand-pull inflation, which results from a rise in spending. The increased demand for goods and services surpasses the supply, leading to an upsurge in prices. To illustrate this point, let's look at a hypothetical case where a baker sells roughly 1,000 loaves of bread each week.

If the demand for bread dramatically increased due to better economic conditions, the baker's bread price would most likely rise. This is because the baker's production capacity is limited to 1,000 loaves per week. Although the baker could recruit more staff and build more ovens, it would take some time.

The sudden surge in bread demand would mean that there are more customers than bread available, and some would be willing to pay higher prices for a loaf. If the economic situation improved, resulting in a surge in the demand for milk, oil, and other products, this would lead to demand-pull inflation. It implies that people are purchasing goods and services more frequently than suppliers can deliver them, resulting in a general increase in prices.

Cost-Push Inflation

The “pushing” of increased raw material or production costs to consumers is called cost-push inflation. To understand this concept, we can revisit our baker who has expanded his production capacity to 4,000 loaves of bread a week. However, a bad wheat harvest means that he must pay more for the wheat required to produce the loaves. This results in him having to increase the prices of the loaves to cover the additional costs, despite there being no increase in consumer demand.

Another example of cost-push inflation is when the government increases the minimum wage, adding to the baker’s production costs and forcing him to raise the prices of his products. Cost-push inflation is often caused by shortages of resources such as wheat or oil, increased taxation by the government on goods, or falling exchange rates that increase the cost of imports.

Built-in Inflation

The concept of built-in inflation is triggered by past economic activities and can be caused by demand-pull and cost-push inflation if they persist over time. It is closely related to inflationary expectations and the price-wage spiral.

Inflationary expectations refer to the idea that after periods of inflation, individuals and businesses anticipate inflation to continue in the future. This can lead employees to demand higher salaries, causing businesses to charge more for their products and services.

The price-wage spiral is a self-reinforcing cycle that may occur when employers and workers can't agree on wages. Workers demand higher wages to protect themselves from anticipated inflation, forcing employers to increase the costs of their products. This can lead to a cycle where workers demand even higher salaries in response to the increased costs of goods and services.

Ways to Fight Inflation

Governments must take action to control inflation, which can be detrimental to the economy. To this end, they adjust monetary and fiscal policies, as well as the money supply. The US Federal Reserve, among other central banks, can change the amount of fiat money in circulation by increasing or decreasing it.

Quantitative easing (QE) is an example of this, where central banks purchase bank assets to infuse the economy with freshly-printed money. However, QE can exacerbate inflation, so it is not used to tackle this issue. On the other hand, quantitative tightening (QT) can reduce inflation by decreasing the money supply. However, it has limited evidence supporting its effectiveness. The primary way central banks control inflation is by raising interest rates.

High Interest Rates

When interest rates rise, borrowing money becomes more costly, leading consumers and businesses to find credit less appealing. With higher interest rates, consumer spending is discouraged, leading to reduced demand for goods and services.

Saving money during this time becomes more attractive, especially for those who earn interest by lending money. However, this may have the downside of slowing down the economy's growth, as businesses and individuals become more cautious about taking out loans to invest or spend.

Altering Fiscal Policy

Governments have multiple options to control inflation, including fiscal policies that alter spending and taxes. While most countries rely on monetary policies, fiscal policies are also an effective tool. For instance, by increasing income tax, individuals would have less disposable income, leading to decreased demand in the market and reduced inflation. However, increasing taxes is often a risky strategy as it may not be well received by the public.

Measuring Inflation With a Price Index

To determine whether inflation needs addressing, the first step is to measure it. Typically, this is done by tracking an index over a set time. In many countries, a Consumer Price Index (CPI) is used to measure inflation. The CPI takes into account the prices of various consumer products by valuing a basket of items and services purchased by households, using a weighted average. This is done periodically, and the score can then be compared with historical ones. The US Bureau of Labor Statistics (BLS) collects this data from stores across the country to ensure accuracy.

For example, a CPI score of 100 might be considered the base year in a calculation, with a score of 110 two years later indicating that prices have increased by 10% over that period. Some inflation is not necessarily a bad thing, as it encourages spending and borrowing, but it is important to monitor the rate of inflation to ensure it does not harm the economy.

Advantages of Inflation

Inflation is a complex topic that cannot be avoided in modern economies. Although it may seem undesirable at first, it has some advantages.

Inflation, contrary to popular belief, can have some benefits for the economy. One advantage is that it can stimulate increased spending, investment, and borrowing, as goods and services will cost more in the future. Additionally, companies can justify selling their goods and services at higher prices during times of inflation, which can lead to higher profits.

Deflation, the opposite of inflation, can have negative impacts on the economy, as it discourages spending and can lead to higher unemployment rates. Consumers tend to delay purchases when prices are falling, and the resulting lack of demand for goods and services can hinder economic growth. Therefore, while inflation may have some downsides, it is generally considered to be a better alternative to deflation.

Disadvantages of Inflation

Inflation has its benefits, but it also has drawbacks that are worth considering. One of the downsides of inflation is the difficulty in determining the appropriate rate of inflation. Failure to control inflation can result in serious consequences, including currency devaluation and hyperinflation. Inflation eats away at an individual's wealth, making $100,000 today worth less than it would be in ten years. Hyperinflation occurs when prices rise by more than 50% in a month, and in such cases, prices can spiral out of control, leading to the destruction of the currency and the economy.

High inflation rates can create uncertainty, causing individuals and businesses to be cautious with their money, leading to less investment and economic growth. Government interventionism in controlling inflation is also a source of opposition for some, as it goes against free-market principles. Critics argue that the government's ability to "create new money" undermines natural economic principles.

Conclusion

Rising prices due to inflation are an accepted phenomenon that affects the cost of living. When controlled correctly, inflation can positively impact the economy. Flexible fiscal and monetary policies are considered the best remedies in today's world to manage inflation. However, these policies must be carefully implemented to avoid any further damage to the economy.