Inflation is the rate at which the value of a currency falls and, as a result, the general level of prices for goods and services rises.
Inflation is sometimes divided into three types: Demand-Pull inflation, Cost-Driven inflation, and Established inflation. The most widely used inflation indices are the Consumer Price Index (CPI) and the Consumer Price Index (CPI). Inflation can be viewed positively or negatively, depending on the individual perspective and the pace of change. Those who own tangible assets, such as property or stocked goods, may want to see some inflation that increases the value of their assets.
What is Inflation?
Inflation is the decrease in the purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power will occur can be reflected in the increase in the average price level of a basket of selected goods and services in an economy over a given period of time. An increase in the general level of prices, usually expressed as a percentage, means that a currency has bought less than in previous periods.
Inflation can be compared to deflation, which occurs when the purchasing power of money increases and prices fall.
Understanding Inflation
While it is easy to measure price changes of individual products over time, human needs go beyond one or two such products. Individuals need a large and diverse set of products and a range of services to lead a comfortable life. These include commodities such as grain, metals, fuel, utilities such as electricity and transportation, and services such as health, entertainment and labor.
Inflation aims to measure the overall effect of price changes for a diversified set of goods and services and allows a single value representation of the increase in the price level of goods and services in an economy over a given period of time.
As a currency depreciates, prices rise and it buys fewer goods and services. This loss of purchasing power affects the overall cost of living for the common people and ultimately leads to a slowdown in economic growth. The consensus among economists is that sustained inflation occurs when a nation’s money supply growth outstrips economic growth.
To combat this, the appropriate monetary authority, such as a country’s central bank, takes the necessary measures to manage the supply of money and credit to keep inflation within permissible limits and keep the economy running smoothly.
Theoretically, monetarism is a popular theory that explains the relationship between inflation and an economy’s money supply. For example, after the Spanish conquest of the Aztec and Inca empires, large quantities of gold, and especially silver, flowed into the Spanish and other European economies. As the money supply increased rapidly, the value of money fell, contributing to the rapid rise in prices.
Inflation is measured in various ways depending on the types of goods and services being considered and is the opposite of deflation, which refers to the general decline in prices of goods and services when the inflation rate falls below 0%.
Causes of Inflation
An increase in money supply is the root of inflation, but this is through different mechanisms in the economy. can happen. The money supply can be increased by either printing or distributing more money to individuals, by legally devaluing (depreciating) the fiat currency, by lending more (most commonly) new money as backup account loans.
In all these cases of money supply increase, money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: demand-side inflation, cost-driven inflation, and established inflation.
Demand-Pull Effect
Demand-pull inflation, an increase in the money and credit supply, causes the overall demand for goods and services in an economy to increase faster than the economy’s productive capacity. occurs when encouraged. This increases demand and leads to price increases.
When more money is available to individuals, positive consumer sentiment leads to higher spending, and this increased demand drives prices higher. With higher demand and less elastic supply, it creates a demand-supply gap, resulting in higher prices.
Cost-Push Effect
Cost inflation is the result of an increase in prices working through production process inputs. The cost of any intermediate goods rises when additions to the money and credit supply are channeled into markets for a commodity or other asset, especially when it is accompanied by an adverse economic shock to the supply of the underlying commodity.
These developments lead to higher costs for the finished product or service and lead to increased consumer prices. For example, when the expansion of the money supply creates a speculative boom in oil prices, the energy cost of any use may rise and contribute to higher consumer prices, which is reflected in various measures of inflation.
Internal Inflation
Resident inflation relates to adaptive expectations, the idea that people expect current rates of inflation to continue into the future. As the price of goods and services rises, workers and others begin to think that they will continue to rise at a similar rate in the future and incur more costs or wages to maintain their standard of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor triggers the other, and vice versa.
Price Index Types
Depending on the selected goods and services group, more than one goods basket type is calculated and followed as price indices. The most widely used price indices are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
Consumer Price Index
CPI is a measure that examines the weighted average price of a basket of goods and services that are primary consumer needs. These include transportation, meals and medical care. The CPI is calculated by taking the price changes for each product in a predetermined basket of goods and averaging them by their relative weights in the entire basket. The prices in question are the retail prices of each product that can be purchased by individual citizens.
Changes in the CPI are used to evaluate price changes associated with the cost of living, making it one of the most commonly used statistics to identify periods of inflation or deflation.
Producer Price Index
The producer price index is a family of indexes that measures the average change in sales prices of domestic intermediate goods and service producers over time. PPI measures price changes from the seller’s perspective and differs from the CPI, which measures price changes from the buyer’s perspective.
In all such variants, it is possible that an increase in the price of one component (eg oil) offsets to some extent the price decrease of another component (eg wheat). In general, each index represents the average weighted price change for certain components that may prevail at the overall economy, sector or commodity level.
Pros and Cons of Inflation
Inflation can be interpreted as a good or bad thing depending on which side is chosen and how quickly change occurs.
For example, people who own tangible assets that are priced in currency, such as property or inventories, may want to see inflation where they can sell at a higher rate because it raises the price of their assets. However, buyers of such assets may be dissatisfied with inflation as they will have to spend more money. Inflation-linked bonds are another popular option for investors to profit from inflation.
On the other hand, people who hold currency-denominated assets such as cash or bonds may dislike inflation as it erodes the true value of their assets. Investors looking to protect their portfolios from inflation should consider inflation-protected asset classes such as gold, commodities, and real estate investment trusts (REITs).
Inflation encourages speculation as both businesses in risky projects and individuals in companies’ stocks expect better returns from inflation. An optimum level of inflation is often encouraged to encourage spending rather than saving to a certain degree. If the purchasing power of money declines over time, there may be a greater incentive to spend now rather than save and spend later. It can increase spending, which can increase economic activity in a country. A balanced approach is thought to keep the inflation value within an optimum and desirable range.
High and volatile inflation rates can place huge costs on an economy. Businesses, workers and consumers must take into account the effects of generally rising prices in their buying, selling and planning decisions. This adds an additional source of uncertainty to the economy because they can make an incorrect prediction about the future inflation rate. The time and resources spent researching, predicting and adjusting economic behavior are expected to rise to the general price level rather than the actual economic fundamentals, which inevitably represent a cost to the economy as a whole.
Even a low, stable and easily predictable rate of inflation can cause serious problems in the economy because of how, where and when new money enters the economy, which some consider to be otherwise optimal. Whenever new money and credit enter the economy, it is always in the hands of certain individuals or business firms, and the process of adjusting the price level to the new money supply proceeds and circulates as they spend the new money. account for the economy.
Along the way, it raises some prices first and then raises other prices. This sequential change in purchasing power and prices (known as the Cantillon effect) means that the inflation process not only increases the overall price level over time, but also distorts relative prices, wages, and rates of return along the way. Economists generally understand that it is not good for the economy for relative prices to move away from their economic equilibrium, and even Austrian economists believe that this process is the main driver of economic recession cycles.
What are the Effects of Inflation?
Inflation can affect the economy in various ways. For example, if inflation causes a country’s currency to fall, this can benefit exporters by making their goods more affordable when priced in foreign countries’ currency.
On the other hand, this can hurt importers by making foreign goods more expensive. Higher inflation can also spur spending, as consumers will aim to purchase goods quickly before their prices rise further. Savers may find that the true value of their savings erodes, limiting their ability to spend or invest in the future.
