Explain it to me as if I were five years old (ELI5)

Have you ever heard your grandmother talk about how everything was cheaper when she was younger? It's because of inflation. This happens due to irregularities in the supply and demand of products and services which, in turn, lead to an increase in prices.

There are some advantages, but generally, too much inflation is a bad thing: why would you save your money if it will be worth less tomorrow? In times of very high inflation, governments implement control policies that aim to reduce the population's spending.

Content

• Introduction

• Causes of inflation

  • Demand inflation

  • Cost inflation

  • Structural inflation

• Actions to combat inflation

  • Higher interest rates

  • Changes in fiscal policy

• Measuring inflation with a price index

• Pros and cons of inflation

  • Pros of inflation

  • Cons of inflation

• Final considerations

Introduction

Inflation can be defined as the reduction in the purchasing power of a given currency. This is the continuous increase in the price of products and services in an economy.

While “relative price change” usually means that only one or two products have seen a price increase, inflation refers to an increase in the costs of almost every item in the economy. Furthermore, inflation is a long-term phenomenon, that is, for inflation to exist, the increase in prices must be continuous and not just a sporadic event.

Most countries carry out annual measurements and publications of inflation rates. Generally, you will see inflation expressed as a percentage change, i.e. growth or decline compared to the previous period.

In this article, we will talk about the different causes of inflation, ways to measure it and the impacts (positive and negative) it can have on the country's economy.

Causes of inflation

Basically, there are two common causes of inflation. The first occurs when the quantity of coins in circulation (supply/supply) increases rapidly. For example, when Europeans colonized the Western Hemisphere in the 15th century, large quantities of gold and silver were brought to Europe causing inflation (supply was too high).

The second cause is when there is a shortage in the supply of a specific product that is in high demand. This can trigger an increase in the price of that product, which affects the country's economy. The result can be a general increase in prices for almost all products and services.

Going deeper, we can list different types of events that lead to inflation. In this article, we will describe demand-pull inflation, cost-push inflation and structural inflation (built-in inflation). Although there are other variations, these are the main types of the “triangle model”, proposed by economist Robert J. Gordon.

Demand inflation

Demand-pull inflation is the most common type of inflation, caused by increased spending. In this case, demand exceeds supply of products and services – which creates a phenomenon that causes prices to rise.

To illustrate this, consider a market where a baker sells his products. It is capable of producing approximately 1,000 loaves of bread per week. So far, everything works well, as he sells approximately the same amount every week.

Now, suppose there is a large increase in the demand for bread, caused by the increase in consumers' purchasing power, in a scenario of improving economic conditions, for example. In this scenario, the baker is likely to increase the price of the bread.

Why? Well, remember that the baker has a production capacity limited to approximately 1,000 loaves per week. Neither your team nor your furnaces can produce more than this amount. He could buy more ovens and hire more employees, but this expansion of his business would take time and require investment.

So we have a lot of customers and we don't have enough bread for everyone. As a result, some customers will be willing to pay higher prices for bread, which would generate a natural effect of increasing prices on the part of the baker.

Now, imagine that in addition to the increase in demand for bread, better economic conditions also generated an increase in demand for milk, oil and several other products. This is exactly the definition of demand inflation. People buy more and more products so that demand exceeds supply – causing prices to rise.

Cost inflation

Cost inflation occurs when prices rise as a result of an increase in raw material or production costs. As the name in English suggests (cost-push inflation), costs are “pushed”, that is, passed on to the consumer.

Let's go back to the baker example. Suppose he invested in new ovens and hired new staff to increase his production capacity to 4,000 loaves of bread per week. At this point, supply meets demand and everyone is happy.

However, worrying news arrives for the baker. The wheat harvest is particularly bad this season, which means there is not enough wheat supply for all the bakeries in the region. Therefore, the baker must pay more for the wheat needed to produce bread. With this increase in production costs, it will need to pass on the same increase to the price of bread, even though consumer demand has not increased.

Another possibility would be for the government to increase the minimum wage. This would also increase the baker's production costs, which in turn would increase the price of bread.

On a large scale, cost inflation is usually caused by shortages of inputs (such as wheat or oil), increased taxes on products, or falling exchange rates (which increase the cost of imported products).

Structural inflation

Structural inflation (built-in inflation), also called hangover inflation, is a type of inflation that derives from previous economic activities. Therefore, it can be triggered by the two previous causes of inflation, if they persist over time. Structural inflation is closely related to the concepts of inflationary expectations and price-wage spirals.

The concept of inflationary expectations implies the idea that – after periods of inflation – individuals and companies have the expectation that inflation will persist in the future. For example, if there is a history of inflation in previous years, employees are more likely to negotiate higher salaries, causing companies to charge more for their products and services.

The concept of the wage-price spiral is linked to the tendency of structural inflation to cause more inflation. It can occur when employees and companies cannot reach an agreement on the amount of their salaries. For example, while workers demand higher wages in order to protect their assets from expected inflation (inflationary expectations), companies are forced to pass on these increased costs to their products and services. This can generate a cycle where workers demand even higher wages in response to the rising costs of products and services – and this cycle continues again and again.

Actions to combat inflation

Uncontrolled inflation can be harmful to a country's economy, so the expectation is that governments will take measures to limit the impacts of inflation. This can be done by controlling the supply/issuance of currency and also by making changes to the country’s  monetary and  fiscal policy.

Central banks (such as the United States Federal Reserve) have the power to change the supply of fiat money, increasing or decreasing the amount in circulation. A common example is quantitative easing (QE), where central banks buy assets from banks to inject newly printed money into the economy. This measure can actually worsen inflation, so it is not used when inflation is the problem.

The opposite of QE is quantitative tightening (QT), which is a monetary policy capable of reducing inflation by decreasing the money supply. However, there is little evidence supporting QT as an effective inflation-fighting action. In practice, most central banks control inflation by increasing interest rates.

Higher interest rates

Higher interest rates mean more expensive financing. As a result, credit becomes less attractive to consumers and businesses. Especially for consumers, rising interest rates discourage spending, causing demand for products and services to decrease.

In periods of high interest rates, it becomes more attractive to save money, especially for those who take out loans to earn interest. However, there is a drop in the economy's growth potential, as companies and individuals are more cautious when applying for credit, investing in expanding their businesses or even spending on consumer goods.

Changes in fiscal policy

Although most countries use monetary policies to control inflation, changing fiscal policy is also an option. Basically, fiscal policy refers to government spending and tax adjustments to influence the country's economy.

If governments increase the income tax rate, for example, workers will have less disposable income, which would lead to a reduction in market demand and, theoretically, should reduce inflation. However, this is a dangerous path, as the population may react unfavorably to tax increases.

Measuring inflation with a price index

We have already described some measures used to combat inflation, but how do we know if, in fact, it needs to be combated? The first step, obviously, is to measure it. Typically, this is done by tracking an index over a set period of time. In many countries, a Consumer Price Index (or CPI) is the measure of inflation used.

The CPI takes into account the prices of a wide range of consumer products, using a weighted average to value items and services purchased by households. This index is measured with a certain frequency and the result is compared with historical results. Entities like the US Bureau of Labor Statistics (BLS) collect this data from traders across the country to ensure their calculations are as accurate as possible.

In calculating the CPI, we could obtain, for example, a score of 100 for the “base year” and then a score of 110 two years later. This indicates that in two years there has been an overall 10% increase in prices.

The presence of a small rate of inflation is not necessarily a bad thing as it is a natural occurrence in current fiat currency systems. Inflation is actually somewhat beneficial as it encourages spending and borrowing. It is important to pay attention to the inflation rate to ensure that it does not have negative effects on the economy.

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Pros and cons of inflation

Inflation may seem like something worth avoiding completely but it remains an integral part of modern economies, so it's an issue that's always on the agenda. Let's look at some of the advantages and disadvantages of inflation.

Pros of inflation

Increase in spending, investments and loans

As we mentioned previously, a low inflation rate can benefit the economy by stimulating spending, investment, borrowing and financing. This is when it makes more sense to purchase products or services, as inflation means that the same amount of money has lower purchasing power in the future.

Increased profits

Inflation leads companies to increase the prices of their products and services, in an attempt to protect themselves from its effects. These price increases may be justified by inflation, but there is often a price increase in search of additional profit.

It's better than deflation

As you can imagine from the name itself, deflation is the opposite of inflation, that is, it involves falling prices over time. In a deflation scenario, as prices are falling, it starts to make more sense for consumers to postpone their purchases, as they can get even better prices if they wait a little. In this way, the demand for products and services is reduced, negatively impacting the economy.

Historically, periods of deflation have resulted in higher unemployment rates and a shift toward hoarding money, as well as less incentive to spend and invest. Although it is not necessarily bad for the individual, deflation tends to harm the country's economic growth.

Cons of inflation

Currency devaluation and hyperinflation

Finding the ideal inflation rate is difficult and not controlling it can have catastrophic consequences. This degrades the wealth that individuals have. For example: if you store $100,000 in cash inside your mattress today, it won't have the same purchasing power ten years from now.

The high rate of inflation can lead to hyperinflation, which occurs when prices rise by more than 50% in a month. For example, you would pay $15 for a basic necessity item that cost just $10 a few weeks ago. In periods of hyperinflation, the rate of price increases often exceeds 50%, destroying the country's currency and economy.

Uncertainty

In a scenario of high inflation rates, uncertainty generally predominates. Because they do not know about the future of the country's economy, individuals and companies become more cautious with their money – consequently, there is less investment and less economic growth.

Government interventionism

Some experts oppose the government's idea of ​​trying to control inflation, citing free market principles. They argue that the government’s ability to “print money” (or Brrrrr, a popular term in the cryptocurrency world) ruins natural economic principles.

Final considerations

The effects of inflation generate increases in prices and the cost of living over time. It is a phenomenon present in world economies and if controlled correctly, it can be beneficial for economies.

In today's world, the best solutions seem to lie in flexible fiscal and monetary policies that allow governments to adapt to keep prices rising but under control. However, these policies must be implemented very carefully, or they could end up causing even more damage to the economy.

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