Inflation: Unraveling the Basics
Inflation is an economic concept that refers to the general increase in the price level of goods and services in an economy over a period of time. In other words, it is the rate at which the purchasing power of a currency declines, leading to a decrease in the value of money. When inflation occurs, each unit of currency buys fewer goods and services than it did before.
Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated—for certain goods, such as food, or for services, such as a haircut, for example. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.
In a market economy, prices for goods and services can always change. Some prices rise; some prices fall. Inflation occurs when there is a broad increase in the prices of goods and services, not just of individual items; it means, your money can buy less goods today than you could yesterday. For example, a few years ago, you could buy a packet of chips for $1. Your 1 dollar note does not have the power to buy that same packet of chips now because the same now costs $2 or more. This is because of Inflation. In other words, inflation reduces the value of the currency over time.
Most countries are currently under the inflationary pressure and the central banks are having a hard time controlling it. Let us understand more about what inflation really is and how it works.
How is Inflation Measured?
Inflation is typically measured using various economic indicators and price indices. The two most commonly used measures of inflation are the Consumer Price Index (CPI) and the Producer Price Index (PPI). Here's how each of these measures works:
Consumer Price Index (CPI):
The CPI is one of the most widely used measures of inflation and reflects changes in the average prices paid by urban consumers for a basket of goods and services over time. It measures the ongoing change of the costs of goods and services. This can include almost any good or service, like transportation, medical care, food or other merchandise items. Many use it to predict and determine the cost of living and economic growth in certain areas. This is one of the more popular ways for professionals within the economic or financial industries to locate inflation or deflation periods within the economy.
Producer’s Price Index:
The PPI, also known as the Wholesale Price Index (WPI) in some countries, measures the average changes in prices received by producers for their goods and services. It provides insights into inflationary pressures at the producer level and can be an early indicator of potential price changes for consumers.
What Are the Main Causes of Inflation?
Inflation can be caused by a variety of factors, and economists often categorize these causes into different types of inflation. Here are some of the main causes of inflation:
Demand-Pull Inflation:
This occurs when the demand for goods and services in an economy exceeds their supply. It can be caused by factors such as increased consumer spending, government expenditure, or investment. When demand exceeds supply, businesses may raise prices to take advantage of the situation. We can take instances of when the price of tomatoes recently increased to a peak high because of increased demand but insufficient availability.
Cost-Push Inflation:
Cost-push inflation is driven by increases in the production costs of goods and services. These cost increases can result from factors such as rising wages, higher raw material prices, or increased energy costs. When businesses face higher expenses, they often pass those costs on to consumers through price hikes. For example, it costs a producer $1 to make a pen and he sells it for $1.2. If the prices of the materials that make a pen increase such that it now costs the producer $1.5 to make a pen, will he still sell it for $1.2? Definitely not! He’ll now charge a price higher than that of his cost price and this price rise is what Inflation is.
Built-In Inflation (Wage-Price Spiral):
This type of inflation is a self-perpetuating cycle. It starts with workers demanding higher wages to maintain their purchasing power because of the price rise. This increase in the wages leads to an increase in per unit cost to the producer who in turn again increases the price of the commodity to cover up for the increased cost.
For example, the same producer who was making a pen at the cost of $1 and selling it for $1.2 has some workers who work for him. If the workers demand higher wages to maintain their purchasing power because of the price rise, then the indirect cost of the pen will no longer be limited to $1 and hence each pen’s production cost is now higher. To make up for the increase in the wages and cost of the pen, the producer now demands a price of more than $1.2 for the same pen. To maintain their purchasing power against this increase in prices, the workers again demand an increase in their wages and this cycle goes on and on which is very well known as the concept of Wage-Price Spiral in economics.
Is Inflation Good For the Economy?
Inflation can have both positive and negative effects on an economy, and its impact depends on the rate and stability of inflation, as well as the overall economic context. Here are the potential advantages (goods) and disadvantages (bads) of inflation:
The Advantages of Inflation:
Encourages Spending and Investment:
Mild inflation can encourage consumers to spend and businesses to invest rather than hoard (hold and not spend) cash. When people expect prices to rise, they are more likely to make purchases and invest in assets like stocks and real estate, which can stimulate economic growth.
Debt Reduction:
Inflation erodes the real value of debt. Borrowers who have fixed-rate loans benefit from inflation because the amount they owe in real terms becomes less burdensome over time. This can be particularly advantageous for individuals with mortgages or long-term loans.
Asset Appreciation:
Some assets, such as real estate and stocks, tend to appreciate in value during periods of moderate inflation, potentially benefiting investors.
The Disadvantages of Inflation:
Inflation is a common stage in every economy. Its occurrence is normal. However, if it is not managed appropriately, it can create huge monetary pressure on individuals, companies, and the government. Hence, it is essential to manage inflation to be used as an opportunity for growth.
Reduces Purchasing Power:
Over time, a higher inflation rate reduces households' purchasing power. The increase in the rate of prices of goods doesn't match the increase in income. Since the middle and lower section of the population has limited resources to survive, any negative impact on their purchasing power creates a major negative impact and questions their survival. Hence, inflation drastically impacts the purchasing power of individuals and questions the survival of individuals in an economy.
Higher Interest Rates:
When interest rates are low, more people can borrow money from banks and financial institutions, which increases the amount of money circulating in the economy. This, in turn, leads to higher overall demand for goods and services. To prevent excessive inflation caused by increased borrowing and spending, central banks raise interest rates. This higher cost of borrowing reduces the supply of money and slows down demand, discouraging people from borrowing and spending excessively.
In 2022, to combat inflation, the Fed started raising its rate, which is a process that continues into 2023. In March 2020, the target rate was between 0% and 0.25%. On July 26, 2023, the FOMC (Federal Open Market Committee, Fed’s chief body of monetary policy) made the latest increase, setting the target fed funds rate between 5.25% and 5.5%. The group said the increase was necessary to meet its target of maximum employment and a 2% inflation rate.
Uncertainty:
High or unpredictable inflation can create uncertainty in the economy. Businesses may hesitate to invest or make long-term plans, and consumers may be uncertain about the future value of their money.
Currency Devaluation:
Prolonged or hyperinflation can lead to the devaluation of a country's currency, causing significant economic instability and undermining international trade.
The Bottom Line
Inflation is a massive problem for the whole economy if not managed properly. It impacts purchasing power and productivity in the longer run. However, if managed properly, a moderate inflation rate is an opportunity for the economy to grow. The middle and poor populations face the worst impact because of the high inflation rate. Entrepreneurs need to manage demand and supply levels so that the economy can utilize the excess demand situation of inflation as an opportunity to increase employment and production.
