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03.11.2022
Inflation in Economics: What It Is, Definition, Meaning, Causes


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Inflation is a key economic concept that refers to a sustained increase in the general level of prices for goods and services. It's one of the most critical measures of the overall health of an economy. Although it is one of the most discussed topics worldwide, the media usually draws more attention to its causes and dangers rather than explaining its meaning. 

In this article, we will dive deeper into the definition of inflation, explain what high and low inflation rates are, discuss inflation measurement techniques, explore its advantages and disadvantages, and more.

What is inflation?

Inflation is an economic phenomenon characterized by a sustained increase in the prices of goods and services, and consequently, a decrease in the purchasing power of a currency. It occurs when the demand for products and/or services exceeds the available supply, resulting in rising costs.

Inflation is an essential metric in evaluating economic health and stability. Economies with a 2 percent inflation rate are considered to have stable prices, while those exceeding that level are likely to face the negative side of this economic phenomenon. Being notorious for its potential dangers, inflation is closely monitored by central banks and other economic authorities. By understanding and keeping an eye on this concept and its causes, policymakers can control and mitigate its harmful effects.

To get a better understanding of inflation, let’s consider an example. If the inflation rate is 2%, and a loaf of bread costs $2 today, then next year the same loaf of bread will cost $2.04. In other words, the buying power of a dollar has decreased by 2%. Although inflation has a greater impact on consumers, it also affects businesses. For example, if the inflation rate is running at 3% per year, then a business needs to raise its prices by 3% just to stay afloat. This can quickly lead to a spiral of ever-increasing prices, which can be very difficult to stop. 

What Is the difference between inflation and deflation?

Deflation is the exact opposite of inflation. While inflation refers to growth in the price level due to an increase of money in supply, deflation happens when prices of goods and services go down since there is not enough money in circulation to purchase them.

Let’s have a look at an example. Say there is one very popular model of cellphone on the market. Many companies start to produce similar products with the same features to stay strong among the competition. However, soon there are more phones than customers are ready to purchase, thus, companies don’t have any other choice but to decrease prices to sell them. 

While deflation may seem like a very positive thing, it can actually be quite harmful to an economy. It can result in hoarding, as people anticipate prices to continue falling. This can lead to a decrease in production and investment, as businesses cut back on expenses. Moreover, deflation can create a debt trap, since the real value of debt increases as prices decline. As a result, deflation can be a serious drag on an economy, leading to slower growth and higher unemployment. Thus, the Federal Reserve of the US and central banks of other countries try to stop deflation in its early stages.

Understanding inflation

As mentioned above, inflation is a measurement of how fast the level of prices for goods and services is going up. Although this phenomenon is more often discussed in a negative context, it could also have some positive effects. It can lead to higher wages as businesses try to keep up with the rising cost of living. This can help to reduce poverty and increase the standard of living. In addition, inflation can encourage spending and investment, as people are more likely to buy items before prices go up any further. However, it’s crucial to underline that a high inflation rate is detrimental to an economy. It can be a reason for higher interest rates, which in turn can discourage investment and lead to slower economic growth. 

Regarding types of inflation, here are four of the most common which it is best to be aware of:

  1. Moderate inflation describes a situation where inflation is growing slowly but continuously. The rate of inflation doesn’t usually exceed 2%-3% and is considered natural and healthy for an economy.
  2. Walking inflation is a type of inflation that results in a gradual increase in the prices of goods and services over time. It is named after the way that prices "walk" up gradually at about 3%-10%, rather than spike suddenly.
  3. Galloping inflation is characterized by a rapid and significant increase in prices. The pace of price growth exceeds 10%. Galloping inflation can be difficult to control, and thus can cause economic instability and hardship for consumers. In some cases, it can even lead to hyperinflation.
  4. Hyperinflation is an extreme inflation rate exceeding 50%. It refers to a rapid increase in the level of prices and a rapid decrease in the purchasing power of money. This is not just an undesirable but a disastrous situation for an economy, as people lose confidence in the currency and start saving. Businesses also suffer, as they find it difficult to plan for the future when prices are constantly changing. In some cases, hyperinflation can even lead to the collapse of a currency.

Causes of inflation


The main driving force of inflation is the increasing supply of money in circulation. This situation can be caused by various actions determined by the monetary policy of a state, for example, issuing more money, devaluating national currency, etc. The result of these actions is growing prices and decreasing purchasing power of the tender currency. 

The causes of inflation are usually divided into three big groups: demand-pull inflation, cost-push inflation, and built-in inflation. Let’s have a closer look at them.

Demand-Pull Effect

Demand-pull inflation occurs when the demand for goods and services exceeds the supply, leading to inflation. For example, in the post-COVID period, there was a fast-growing demand for travel services, in particular air flight tickets. However, the supply couldn’t withstand it, and thus the prices grew dramatically. According to the data provided by the Adobe Digital Economy Index, the cost of air flight tickets surged by 28% compared to the period before the pandemic with its restrictions (March 2019). 

The demand-pull effect is one of the most widely accepted explanations for inflation and has been used to help explain episodes of high inflation in the past.

Built-in Inflation

Built-in inflation describes a situation when demand-pull or cost-push inflation occurs, employees expect it to persist in the future, and want an increase in wages. Businesses agree to adjust the salary level to the current market prices while increasing the prices for their products or services to maintain the same profit.

While built-in inflation can be beneficial to some people, it can also be detrimental to others. For example, people on fixed incomes may find that their purchasing power decreases over time as prices rise faster than their incomes. Similarly, businesses may find that their costs start to exceed their revenue, which can lead to financial difficulties. Built-in inflation can also lead to higher interest rates and higher levels of debt, as lenders attempt to offset the risk of inflation.

Why are there so many different price indexes and measures of inflation?

There is a wide variety of different price indexes and measures of inflation because all of them have a particular purpose, work better for a specific sphere, and focus on different aspects of this economic phenomenon. 

One of the most common measures of inflation is the Consumer Price Index (CPI), which tracks the prices of a basket of goods and services that are typically purchased by consumers. However, there are also measures of inflation that focus on specific goods and services, such as housing or healthcare. In addition, some measures of inflation are based on changes in prices over time, while others focus on the level of prices. As a result, there is no one perfect mechanism for measuring inflation; instead, economists use a variety of different indexes to get a useful snapshot of inflation trends in the economy.

How is inflation measured?

As mentioned above, there is a wide choice of indexes and measures of inflation. However, the most common ones include the Consumer Price Index (CPI), the Wholesale Price Index (WPI), the Producer Price Index (PPI), and the GDP deflator. Let’s find out the difference between them.

Consumer Price Index (CPI)

The Consumer Price Inflation Index is one of the most popular tools used for measuring the rate of inflation. It stands for a basket of goods and services that are representative of what consumers purchase. The CPI includes items such as food, housing, transportation, and healthcare. This index is calculated by taking the price of the consumer basket in a particular year and dividing it by the price of the same basket in the base year. The result of the CPI is then multiplied by 100 to get the percentage change in prices. For example, if the inflation rate was 2% last year, that means that on average, prices increased by 2% over the course of the year.

Wholesale Price Index (WPI)

The Wholesale Price Index is a measure of the average change in prices paid by wholesalers for goods and services in an economy. In contrast to the CPI, which is based only on consumer goods, the WPI covers three main sectors: primary articles, fuel and power, and manufactured products.

  • The primary articles sector includes agricultural products, minerals, and metals. 
  • The fuel and power sector covers products such as coal, crude oil, and natural gas.
  • The manufactured products sector comprises finished goods and intermediate goods.

The WPI is widely used by businesses to make pricing decisions, as well as by economists to assess the health of the economy.

Producer Price Index (PPI)

The Producer Price Index (PPI) is a measure of the average change in prices received by domestic producers for the sale of their output. The weights used in the index are based on production values for each industry. The PPI is a weighted average of prices and, therefore, it is not necessarily representative of the price change experienced by any one particular producer.

The PPI has many use cases. Apart from being an indicator of inflation, it serves as a measure of the producer’s ability to pass on higher costs to consumers. The PPI can also be used to deflate other economic indicators, such as gross domestic product (GDP).

GDP Deflator

The Gross domestic product (GDP) deflator is one of the most broad-based price indexes. Apart from being a measure of inflation, it refers to the prices of all final goods and services produced in an economy. This price index is used to adjust nominal GDP figures to real GDP figures. The index is calculated by dividing nominal GDP by real GDP and then multiplying by 100. For example, if nominal GDP in a given year is $10 trillion and real GDP is $9 trillion, then the GDP deflator would be 111.1 ((10/9)*100). This means that prices have risen by 11.1% over the course of the year.

The Formula for Measuring Inflation

To calculate the inflation rate, it’s necessary to know a product’s price on two particular dates. Then, it’s necessary to subtract the CPI of the beginning date from the CPI of the end date and divide the result by the CPI of the beginning date. To receive the rate of inflation in percentage, the result of this calculation should then be multiplied by 100. The formula for measuring inflation is as follows:

Here is an example of the price of bread. First, let’s choose the beginning and the end date: 2021 and 2022 respectively. The price of bread in 2021 was $5.10, while in 2022, it rose to $5.43. As a base year, let's take 2020, when the price of bread was $5. Then, it’s necessary to calculate the CPI for each chosen year following the formula:

CPI (2020) = ($5/$5)*100=100

CPI (2021) = ($5.1/$5)*100=102 (beginning date)

CPI (2022) = ($5.4/$5)*100=108 (end date)

Now, it’s possible to calculate the inflation rate using the formula described above:

Inflation rate= ((108-102)/102)*100 = 5.88%

Advantages and disadvantages of inflation

Inflation is a key term in economics, and although it is more often discussed from a negative perspective, just as with anything, it comes with both benefits and drawbacks. Let’s take a look at them.

Pros

  1. Encourages spending and investment. People are more likely to buy goods and services when they believe prices will rise in the future.
  2. Encourages borrowing and lending. With moderate inflation, people are more likely to take out loans as they expect the value of their money to increase. This increased borrowing can lead to higher economic growth and job creation as businesses are able to invest and expand.
  3. Boosts economic growth. Inflation gives people an incentive to spend more money rather than save it. When savers see that the purchasing power of their savings is declining, they're more likely to increase their personal consumption expenditures on goods and services, this way fostering the growth of production and the entire economy.

Cons

Inflation over 2-3% is a matter of concern. The higher the rate of inflation, the more serious the problems it may bring to the economy. Some of them include, but are not limited to:

  1. Instability. When inflation becomes too high, it can erode people's savings, reduce their purchasing power, and make it difficult for businesses to plan and budget for the future. In extreme cases, high inflation can even lead to economic collapse.
  2. High inflation discourages investments. This is because it decreases the return on investment. For example, if you invest $1,000 at a 10% interest rate, you would expect to earn $100 in interest. However, if inflation is 5%, the purchasing power of your accrued interest would be reduced to $95. Reduction in investments can choke off economic growth and eventually lead to recession.
  3. Decrease in real wages. When inflation is high, prices rise quickly and significantly, while purchasing power drops dramatically. This is why inflation is often cited as a cause of declining real wages, because while nominal wages may increase with inflation, real wages (wages adjusted for purchasing power) may stay the same or even decrease.

Controlling inflation

Inflation has a major impact on an economy. If it is too high, it can lead to economic recession, as people are less likely to spend money when they believe that prices will continue to rise in the future. On the other hand, if inflation is too low, it can lead to stagnation, as businesses are less likely to invest in new products and services. In order to maintain a healthy economy, the Federal Reserve bank and other policymakers have to control inflation. Here are three common ways they can do it:

  1. Interest rates. By increasing interest rates, central banks discourage people from borrowing money. As a result, the demand falls, and so do the prices.
  2. Reserve requirements. If a bank increases reserve requirements, it means that it will need more money to keep in reserve. Thus, their lending amount decreases, which leads to lower consumer spending, and, as a result, to lower prices.
  3. Money supply. As previously mentioned, a growing amount of money in circulation is the main cause of inflation. Thus, a reduced supply of money will lead to a decrease in inflation.

How to beat inflation with investments

For investors, inflation can pose a challenge in terms of preserving the value of their portfolios. However, there are particular types of financial instruments that can settle this issue better than others.

Stocks

One way to protect yourself from inflation is to invest in the stock market. Over the long term, stocks have outperformed other asset classes. This is because companies are able to make their stock price increase in line with inflation, meaning that the value of investments will remain the same. In addition, as companies grow their earnings, they often return some of this growth to shareholders in the form of dividend payments. These payments can help offset any decline in the purchasing power of the investment. Finally, stocks come with rather high liquidity, which means that they can easily be sold if an investor needs to access cash.

Inflation-Indexed Bonds

Inflation-indexed bonds are financial products that are linked to an index that measures changes in the cost of living. This means that they can help to offset the effects of rising prices, as when inflation grows, the interest payments on these bonds also increase. 

Physical Assets and Commodities

Another way to beat inflation is to invest in physical assets such as real estate or gold. These financial instruments tend to go up in value as inflation increases. 

Commodities are another asset class that appreciates in line with inflation. These are items used in the production of other goods and services (e.g. oil, wheat, etc.). Commodities are vital components of the global economy, and their prices are highly sensitive to changes in supply and demand. When inflationary pressures rise, central banks frequently respond by raising interest rates, which increases commodity demand as investors seek to hedge against rising prices.

FAQ

What is a simple definition of inflation?

Inflation refers to a sustained increase in the price level of goods and services in an economy. In other words, it is a measure of how much more expensive a consumer basket has become over a period of time. The most common way to measure the inflation rate is through the consumer price index (CPI), which tracks the prices of a basket of goods and services that are typically purchased by households. 

What are the 3 main causes of inflation?

The primary causes of inflation are:

1. Demand-pull inflation occurs when consumers anticipate future inflation and begin purchasing more today, causing businesses to raise prices to meet this increased demand.

2.  Cost-push inflation occurs when the cost of production rises, such as with an increase in oil prices or a decrease in productivity. Businesses then pass on these higher costs to customers in the form of higher prices, resulting in inflation.

3.  Built-in inflation refers to rising prices caused by economic lags.

What is an inflation example?

Inflation is the percentage change in the consumer price inflation index over a period of time. The CPI index measures the average price changes paid by consumers for a basket of goods and services. Low inflation indicates that the economy is healthy, while high inflation refers to a struggling economy. The inflation rate can also be used to gauge the purchasing power of a currency. A currency with high inflation will lose value relative to other currencies with lower inflation rates.

What happens during inflation?

Inflation is defined as a sustained increase in the general price level and a decrease in purchasing power. It can be caused by increases in the money supply, cost-push factors such as increases in energy prices, or demand-pull factors such as increases in consumer spending. This economic phenomenon can lead to wage inflation, which occurs when workers demand higher wages in order to maintain their standard of living. Higher inflation rates can also lead to higher interest rates and lower levels of economic growth.

What is hyperinflation?

Hyperinflation is a type of inflation that occurs when the inflation rate is so high that it effectively wipes out the value of money. In such conditions, people may start to hoard essential goods, and the economy can grind to a halt. It’s difficult to have inflation measured in these situations, as the prices of goods and services may change rapidly on a day-to-day basis. As a result, hyperinflation can be extremely damaging to an economy, and it is often accompanied by political instability.