Inflation

What is inflation?

Originally, the term ‘inflation’ was used to describe an increase in the general price level induced by an imbalance between the money supply and trade needs. Today, economists use the term to refer to a rise in the price level. It describes the increase in the prices of goods and services over time.

Usually expressed as a percentage, inflation indicates a decline in the purchasing power of each unit of a nation’s currency. As a result, once prices rise – your money can buy less.

The loss of purchasing power has a great impact on the overall cost of living for the common public, leading to a deceleration in economic growth. To deal with this problem and keep the economy operating smoothly, a country's appropriate authority, such as the central bank, takes the necessary steps to keep inflation within acceptable limits.

Key takeaways

Causes of inflation

There are a few types of inflation:

• Demand-pull inflation. Caused by an increase in aggregate demand, or total spending in an economy. This can happen when consumers increase their spending, or when the government increases its spending.
• Cost-push inflation. Caused by an increase in the prices of production inputs such as labour, materials, and energy. This can happen when companies have to pay more for their inputs, which leads to them increasing their prices to cover the higher costs.
• Monetary inflation. Caused by an increase in the money supply. It can happen when the central bank prints more money, or when banks make more loans. The additional money in circulation causes prices to rise.
• Structural inflation. Caused by a mismatch between supply and demand in the economy. This can happen when there is an imbalance between the number of goods and services produced and the number of people who want to buy them. It can also happen when there is an increase in the cost of production inputs, but the prices of goods and services do not increase as much.

How is inflation measured?

Inflation is typically measured by tracking changes in the prices of a basket of goods and services over time, which is known as the Consumer Price Index (CPI). The CPI is calculated by taking the average of prices of a selection of goods and services, weighting them by their importance, and comparing them to a base period. This measure is used to calculate the cost-of-living index and to gauge the overall change in prices for goods and services over time.

Effects of inflation

Major changes don’t happen overnight. Inflation usually takes its time to creep on the nation. We continue our normal consumption and spending habits, without seeing the almost imperceptible increase of prices. However, the impact of inflation is undoubtedly huge.

Apart from influencing our salaries, it makes food prices go up, transportation charges increase and the cost of other goods and services skyrocket over time.

Here is a good example of inflation: in 1980 in the US a new house would cost around $76,000. The median annual income was around $17,710. In comparison, in 2011, the average house price was around $139,000, while the median annual household income was $50,233. The vast difference in prices was caused by inflation.

A sudden increase in the price of goods and services has a domino effect on the economy. The depreciation of money comes with a decrease in demand for products and services. Unemployment rates rise, as manufacturing firms are forced to lay off workers. The fear of inflation can also result in hoarding, when retailers and consumers buy excessive amounts of certain goods to not pay higher prices once inflation occurs.Note that inflation can be measured in a variety of ways, depending on the types of goods and services considered.

Pros and cons of inflation

Pros

• Inflation can encourage spending and investment, helping to stimulate economic growth.
• It can also help reduce the burden of debt, as the real value of the debt is reduced.
• Inflation can benefit savers, as their money will be worth more in the future.
• It can help reduce unemployment, as businesses are more likely to hire workers if they expect prices to rise.

Cons

• Inflation erodes the purchasing power of money, making it more difficult for people to afford basic necessities.
• It could be difficult for the government to control, leading to periods of high inflation or deflation.
• Inflation may lead to higher interest rates, which could make it more difficult for businesses and individuals to borrow money.
• Inflation can be unfair to those on fixed incomes, as their incomes don’t increase with inflation.

Managing inflation

In order to manage inflation, governments can implement a variety of policies.

Fiscal policy is one of the most important tools and can be used to reduce demand in the economy by increasing taxes, reducing government spending, or raising interest rates.

Monetary policy can also be used to manage inflation. It involves using tools such as the money supply or interest rates to reduce the amount of money in circulation, which can reduce demand and slow the rate of inflation.

Additional policies governments can use to manage inflation include increasing the minimum wage, indexing wages to inflation, or implementing price controls. Governments can also encourage competition in the market by reducing taxes and regulations on businesses, which will increase the supply of goods and services and reduce prices.

Conclusion

Inflation is an economic phenomenon that is the result of an imbalance between supply and demand in the economy. This imbalance causes prices to rise faster than the growth in wages, which can lead to a decrease in purchasing power. Inflation can have a significant impact on an economy, leading to higher costs of goods and services, increased unemployment, and slower economic growth.

It can be difficult to manage, but with the right policies, governments can help to reduce the rate of inflation and ensure that the economy remains stable.

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