Introduction
Have you ever heard your grandmother say that everything was cheap when she was young? The reason is inflation. This phenomenon is caused by irregularities in the supply and demand of products and services, which leads to price increases.
Inflation has its advantages, but in general, too much inflation is a bad thing: if your money is going to be worth less tomorrow, why save money? In order to control excessive inflation, governments around the world will deploy policies aimed at reducing consumption.
Table of contents
Introduction
causes of inflation
demand pull inflation
cost push inflation
Built-in inflation
Remedies for inflation
Raising interest rates
Changing fiscal policy
Measuring inflation with the consumer price index
Pros and cons of inflation
Advantages of inflation
Disadvantages of Inflation
Summarize
Introduction
Inflation can be defined as the decline in the purchasing power of a currency. This means a sustained increase in the prices of goods and services in an economy.
"Relative price changes" usually mean that the price of just one or two goods has increased, while inflation means that the cost of almost all goods in the economy has increased. Inflation is also a secular phenomenon, meaning that the price increases must be continuous and not just occasional.
Inflation is measured annually in most countries. Usually, you'll see inflation rates expressed as a percentage change: an increase or decrease relative to the previous period.
In this article, we will discuss the different causes of inflation, how to measure it, and the effects (both positive and negative) it can have on the economy.
Causes of inflation
At a basic level, we can deduce two common causes of inflation. First, the amount of actual money in circulation (supply) increases rapidly. For example, when European colonists conquered the Western Hemisphere in the 15th century, gold and silver bullion flooded into Europe, which led to inflation (too high a supply).
Secondly, inflation may also occur due to a shortage of a particular good that is in high demand. This may then trigger an increase in the price of that good, which may then spread to other parts of the economy. The result may be a general increase in the prices of almost all goods and services.
But if we dig deeper, we'll find that there are different types of events that can lead to inflation. Here, we distinguish between demand-pull inflation, cost-push inflation, and built-in inflation. There are other variants, but the above are the main types of inflation in the "triangle model" proposed by economist Robert J. Gordon.
Demand-pull inflation
Demand-pull inflation is the most common type of inflation and is caused by increased consumption. In this case, demand exceeds the supply of goods and services, which leads to higher prices.
To illustrate this, let's think about a baker who sells bread in a market. The baker makes about 1,000 loaves of bread per week. This is a good business because he sells about this amount every week.
But suppose the demand for bread increases significantly. Perhaps economic conditions improve, meaning consumers have more money to spend. As a result, we are likely to see an increase in the price of bread sold by bakers.
Why? Because at 1,000 loaves, our baker is operating at full capacity. His staff and ovens can't actually produce more than that. He can add more ovens and hire more staff, but that takes time.
It's too late now. We have too many customers and not enough bread. Some customers are willing to pay more for bread, so it's only natural for bakers to raise their prices accordingly.
Now, in addition to the increased demand for bread, imagine that improved economic conditions also led to an increase in the demand for milk, oil, and several other products. This is the definition of demand-pull inflation. People buy more and more goods, resulting in a shortage of supply and a rise in prices.
cost-push inflation
Cost-push inflation occurs when price levels rise because of increases in raw material or production costs. As the name suggests, these costs are “pushed” to consumers.
Let's go back to the baker's situation. He has installed a new oven, hired additional staff, and is able to produce 4,000 loaves of bread per week. Currently, supply meets demand, and everyone is happy.
One day, the baker heard some bad news. The wheat harvest had been particularly bad this season, which meant that all the bakeries in the area were running low on supplies. The baker had to pay more for the wheat he needed to produce his bread. With this extra expense, he needed to increase the price he charged, but demand from consumers wasn't growing.
Another possibility is that the government raises the minimum wage. This increases the baker's production costs, so he must again raise the price of existing bread.
At the macro level, cost-push inflation is usually caused by a shortage of resources (such as wheat or oil), an increase in government taxes on goods, or a falling exchange rate (making imports more expensive).
Built-in inflation
Built-in inflation (also known as habitual inflation) is a type of inflation that is caused by past economic activity. Therefore, if the first two forms of inflation persist over time, this type of inflation may be triggered. Built-in inflation is closely related to the concepts of inflation expectations and price-wage spirals.
The first concept in the above points refers to the fact that after a period of inflation, individuals and businesses expect inflation to continue in the future. If inflation has occurred in previous years, employees are more likely to negotiate for a pay raise, which in turn causes businesses to charge more for their products and services.
The concept of a price-wage spiral describes the tendency of built-in inflation to trigger rising inflation. This can happen when employers and workers cannot agree on the value of wages. While workers demand higher wages to protect their wealth from expected inflation, employers are forced to increase the cost of their products. This can lead to a self-reinforcing cycle where workers demand further wage increases in response to the increased cost of goods and services, and the cycle continues.
Remedies for inflation
Uncontrolled inflation can be damaging to an economy, so governments have to take a proactive stance to limit the effects of inflation. They can do this by adjusting the money supply and by changing monetary and fiscal policies.
Central banks, such as the Federal Reserve, have the power to change the supply of fiat money by increasing or decreasing the amount in circulation. A common example is quantitative easing (QE), where the central bank buys bank assets to inject newly printed money into the economy. This measure can actually increase inflation, so it is not used when inflation is a problem.
The opposite of quantitative easing is quantitative tightening (QT), a monetary policy that reduces inflation by reducing the money supply. However, there is little evidence to support that QT is a good way to fight inflation. In practice, most central banks control inflation by raising interest rates.
Raising interest rates
Higher interest rates make it more expensive to borrow money. As a result, credit becomes less attractive to consumers and businesses. At the consumer level, higher interest rates discourage spending, leading to a decrease in the quantity of goods and services demanded.
Saving becomes more attractive during such times, and that’s a good thing for people who earn interest by lending money. However, economic growth may be limited as businesses and individuals become more cautious about borrowing to invest or spend.
Changing fiscal policy
While most countries use monetary policy to control inflation, changing fiscal policy is also an option. Fiscal policy refers to spending and tax adjustments that a government makes to influence the economy.
For example, if the government increases the income tax it collects, then individuals' disposable income will again decrease. This in turn will reduce demand in the market, which should theoretically reduce inflation. However, this is a risky move because the public may react negatively to higher taxes.
Measuring inflation with the consumer price index
We've outlined various measures that can be taken to combat inflation, but how do you actually recognize the need to combat inflation in the first place? The obvious first step is to measure inflation. Typically, this is done by tracking an index over a set period of time. In many countries, the Consumer Price Index, or CPI, is the preferred measure of inflation.
The CPI takes into account the prices of a variety of consumer items, using a weighted average to value a basket of goods and services purchased by households. This is done at regular intervals, and the score can then be compared to historical scores. Entities such as the Bureau of Labor Statistics (BLS) collect this data from stores across the country to ensure that the calculations are as accurate as possible.
You might see in your calculations that the CPI score for the "base year" is 100, and then two years later it's 110. You could then conclude that over two years, prices have risen 10%.
A little bit of inflation isn’t necessarily a bad thing. It’s a natural phenomenon in today’s fiat monetary system, and it can have certain benefits because it encourages spending and borrowing. However, it’s important to keep a close eye on inflation rates to ensure that it doesn’t have a negative impact on the economy.
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The pros and cons of inflation
At first glance, inflation might seem like something that is well worth avoiding. But it is part of the modern economy, so inflation is a more nuanced subject in reality. Let’s look at the pros and cons of inflation.
Advantages of inflation
Increase consumption, investment and borrowing
As we've discussed before, a mild rate of inflation can benefit the economy by stimulating spending, investment, and borrowing. Because inflation causes the same amount of cash to buy less in the future, it makes more sense to buy goods or services now.
increase profit
Inflation can cause companies to sell their goods and services at higher prices to protect themselves from the effects of inflation. They have legitimate reasons to raise prices, but they may also raise prices slightly higher than necessary to make extra profit.
This is better than deflation.
As we can easily infer from the name, deflation is the opposite of inflation and is characterized by a decrease in prices over time. Since prices are decreasing, it makes more sense for consumers to postpone purchases because they can get a more desirable price in the near future. This can have a negative impact on the economy because goods and services are not in as high demand.
Historically, periods of deflation have led to higher unemployment and people turning to saving rather than spending. While this isn’t necessarily a bad thing for individuals, deflation tends to hamper economic growth.
Disadvantages of Inflation
Currency Devaluation and Hyperinflation
Finding the right rate of inflation is difficult, and can be disastrous if it gets out of control. Ultimately, it erodes a person’s wealth: if you have $100,000 in cash under your mattress today, it will not buy as much in 10 years.
High inflation can lead to hyperinflation, which is said to occur when prices rise by more than 50% in a month. It's not a good idea to spend $15 on a basic necessity that cost $10 a few weeks ago, but hyperinflation rarely stops there. During hyperinflation, price inflation often exceeds 50%, essentially destroying the currency and the economy.
Uncertainty
If inflation is high, uncertainty reigns. People and businesses are unsure about where the economy is headed, so they use their money more cautiously, which leads to less investment and slower growth.
Government interventionism
Some people object to the idea of the government trying to control inflation, citing free market principles. They argue that the government’s ability to “print more money” (or “printing presses, go!” as it’s known in cryptocurrency circles) undermines natural economic principles.
Summarize
Inflation is such a big thing that we see prices rise over time, leading to a higher cost of living, and we have come to accept it as a phenomenon that can be good for the economy if it is controlled properly.
In today’s world, the best remedy seems to lie in flexible fiscal and monetary policies, which allow governments to make adjustments to curb rising prices. However, such policies must be implemented with great care, otherwise they may end up causing further damage to the economy.