Introduction

Remember your grandparents’ complaints that everything was cheaper when they were children. This is inflation. It occurs due to a mismatch in the supply and demand of goods and services, causing prices to rise.

Inflation has some benefits, but severe inflation is a purely negative phenomenon: consumers feel that there is no point in holding money if the next day it will no longer be worth anything. To reduce inflation, the government may pursue special policies aimed at reducing spending.

Content

• Introduction

• Causes of inflation

  • Demand inflation

  • Cost inflation

  • Built-in inflation

• Measures to reduce inflation

  • Rising interest rates

  • Change in fiscal policy

• Measuring inflation using a price index

• Pros and cons of inflation

  • Pros of inflation

  • Cons of inflation

• Summary

Introduction

Inflation can be described as a decrease in the purchasing power of a currency, which causes an increase in the prices of goods and services in the economy.

While "relative price change" usually means that only one or two goods have increased in price, inflation means that the cost of almost all goods has increased. In addition, inflation is a long-term phenomenon: price increases should not just be a temporary phenomenon, but be sustainable.

Most countries measure inflation rates annually. Typically, inflation is expressed as a percentage increase or decrease relative to the previous period.

In this article, we will look at the causes of inflation, how it is measured, and the impact (positive and negative) it has on the economy.

Causes of inflation

Among the causes of inflation, two main ones can be distinguished. The first is a rapid increase in the volume of currency in circulation (supply). For example, after the conquistadors conquered the Western Hemisphere in the 15th century, gold and silver bullion poured into Europe, which caused inflation (the supply was too great).

The second reason is a lack of supply of a particular product that is in high demand. The price of this commodity rises significantly, which could destroy the rest of the economy. As a result, there will be a general rise in prices for almost all goods and services.

But if we delve deeper into this topic, we can identify certain events that lead to inflation. First of all, it is necessary to distinguish between demand-pull inflation, cost-push inflation and embedded inflation. There are other variations of inflation, but these are the concepts that formed the basis 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 the supply of goods and services, which causes prices to rise.

Suppose a baker sells his products. It can produce about 1,000 loaves of bread per week. His business is going well and he sells about this amount each week.

But suddenly the demand for bread increased greatly. Perhaps economic conditions have improved and consumers are spending more. As a result, the price of a loaf will likely rise as well.

Why? At maximum efficiency, the baker produces 1,000 loaves. Neither the staff nor the number of furnaces allows us to produce more. He could install more ovens and hire more employees, but that takes time.

And in the current situation, we get a lot of paying clients and little bread. Some customers will be willing to pay a higher price, and the baker will increase the price accordingly.

Now imagine that in addition to the increased demand for bread, improved economic conditions also led to an increase in the demand for milk, butter and other products. This situation will be called demand inflation. People are buying more and more goods, demand is exceeding supply, and we are seeing prices rise.

Cost inflation

Cost-push inflation is an increase in prices resulting from increased costs of raw materials or production. Ultimately, these costs are passed on to the consumer.

Let's demonstrate this using the example of a baker. He built new ovens and hired more employees to produce 4,000 loaves of bread a week. Now supply meets demand and everyone is happy.

One day, a baker receives some bad news: the wheat harvest this season has been poor and there will be a shortage. In order not to be left without wheat and continue to produce bread, the baker will have to pay a higher price for wheat. Due to the additional costs, he is forced to raise prices, even if consumer demand has not increased.

This could also happen if the government increases the minimum wage. In this case, the baker's production costs will increase, and he will raise the price of the product.

On a large scale, cost-push inflation is often caused by resource shortages (such as wheat or oil), increased government taxation on goods, or falling exchange rates (making imports more expensive).

Built-in inflation

Embedded inflation (or hangover inflation) occurs as a result of past economic activity. It can be caused by the previous two forms of inflation if their effects last for a long time. Embedded inflation is closely related to the concepts of inflation expectations and price-wage spirals.

According to the concept of inflation expectations, after a period of inflation, people and businesses expect inflation to continue in the future. If there was inflation in the past year, workers will demand higher wages, causing businesses to increase the prices of their products and services.

The price-wage spiral is a concept that illustrates the tendency of built-in inflation to cause more inflation. This occurs when employers and employees cannot agree on wages. If workers demand higher wages to protect against expected inflation, then employers are forced to increase the cost of their products. This creates a self-reinforcing cycle where workers demand ever higher wages in response to rising costs of goods and services, and the cycle continues.

Measures to reduce inflation

Uncontrolled inflation can cause enormous damage to the economy, so governments are proactive in limiting its effects. This is done by changing the volume of money in circulation and making changes to monetary and fiscal policy.

Central banks (such as the US Federal Reserve) can change the money supply by increasing or decreasing the amount of money in circulation. One such example is quantitative easing (QE), which is the central bank's purchase of assets in order to flood the economy with freshly printed money. This measure may also aggravate the situation, which is why governments do not resort to it during inflation.

The opposite measure is quantitative tightening (QT). It is a monetary policy that reduces inflation by reducing the amount of money in circulation. However, there is still insufficient evidence that QT effectively neutralizes the effects of inflation. In practice, most central banks control inflation by raising interest rates.

Rising interest rates

Due to high interest rates, credit becomes less profitable, as a result of which the attractiveness of loans for consumers and businesses decreases. At the consumer level, rising interest rates reduce the purchasing power of the population, and with it the demand for goods and services.

In such conditions, people tend to accumulate money or lend it out in order to receive high interest rates. Because businesses and individuals are reluctant to borrow money for investment or spending, economic growth can be stunted.

Change in fiscal policy

Although most countries use monetary policy to control inflation, this can also be achieved by changing fiscal policy. Fiscal policy is the government's tax policy to influence the economy.

For example, if the government increases taxes, then individuals' incomes decrease. As a result, demand in the market falls, which theoretically should reduce inflation. However, in this case there is a risk of public outrage due to higher taxes.

Measuring inflation using a price index

So, we have listed measures to combat inflation, but how do you understand that the time has come to fight it? First of all, it needs to be measured. Typically, inflation is measured by tracking an index over a period of time. In many countries, the consumer price index (or CPI) is the main measure of inflation.

The CPI takes into account the prices of a wide range of consumer goods, using an average to value a basket of household goods and services. This assessment is made from time to time and compared with previous performance. The U.S. Bureau of Labor Statistics (BLS) and similar organizations collect this data from stores across the country to make the most accurate calculations possible.

One year the CPI may score 100 points, and two years later it may score 110 points. Based on this, we can conclude that prices have increased by 10% in two years.

A little inflation is not always a bad thing. This is common in modern fiat currency systems and is somewhat beneficial as it encourages spending and borrowing. However, it is necessary to monitor the inflation rate to prevent a negative impact on the economy.

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Pros and cons of inflation

At first glance, it may seem that inflation is an exclusively negative phenomenon. However, it is an integral part of the modern economy, so it is a much more multifaceted topic. Let's look at some of the advantages and disadvantages of inflation.

Pros of inflation

Increased spending, investment and borrowing

As mentioned earlier, low inflation can benefit the economy by stimulating spending, investment, and borrowing. Consumers tend to purchase goods and services immediately as their funds quickly lose their purchasing power.

High profit

In order to protect themselves from inflation, companies sell goods and services at higher prices. Of course, they can always justify raising prices, but nothing prevents them from raising prices above what is necessary to make additional profits.

Inflation is better than deflation

As the name suggests, deflation is the antonym of inflation, which is characterized by a decrease in prices over time. As prices fall, consumers try to delay purchasing a product in hopes of getting a better price in the future. Demand for goods and services falls, which has a negative impact on the economy.

History has demonstrated that periods of deflation lead to high unemployment and a shift toward saving and saving rather than spending. While deflation may not have a negative impact on individuals, it does significantly impede economic growth.

Cons of inflation

Devaluation and hyperinflation

Determining the right level of inflation is quite difficult, and inflation getting out of control can lead to catastrophic consequences. Ultimately, people lose their savings: if you have $100,000 in cash under your mattress now, in ten years it will be worth much less.

High inflation can lead to hyperinflation, which is characterized by price increases of more than 50% in one month. Essentials that cost $10 just a week ago are starting to sell for $15, and that's just the beginning. During periods of hyperinflation, price increases exceed 50%, which has a devastating effect on the currency and the economy.

Uncertainty

When inflation rates are high, uncertainty may arise. Individuals and businesses do not know which direction the economy is heading. They try to be more careful with their funds, which leads to a decrease in investment and economic growth.

State intervention

Some oppose government controls on inflation, citing free market principles. Such people believe that the government's ability to “print new money” (a famous meme in the cryptocurrency world, Money Printer Go Brrr) undermines natural economic principles.

Summary

Inflation leads to rising prices and a falling standard of living for citizens. We can only accept this phenomenon: after all, if managed correctly, inflation can benefit the economy.

In the modern world, it can be protected from it by flexible fiscal and monetary policies, which allow governments to adapt in order to curb price increases. However, these policies must be implemented carefully so as not to cause further damage to the economy.