Along with the fluctuations of the economy, inflation is inevitable in every country. But what is inflation? What is the effect of inflation on the economy? Please refer to the article below for more detailed information.
What is inflation?
Inflation is an economic term that describes the general increase in prices and the decrease in the purchasing power of the currency.
- Price increased: In 1950, you could buy a cup of coffee for $0.22 while today a cup of brew costs $2.38.
- The purchasing power of the currency decreased: A basket of goods worth $100 in 1950 would have cost $1,108 today.
Stable inflation at a reasonable level facilitates promoting economic development. However, it becomes a serious problem when it increases too quickly. Money devaluation at a rapid rate can cause the entire economy to spiral out of control.
All governments and central banks try to curb inflation by enacting regulations and monetary policies. Inflation means that the cost of goods and services will rise, the rate of inflation is calculated as a percentage increase or decrease in price over a period of time.
Causes of inflation
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than output.” – Milton Friedman
To put it more simply, inflation occurs when production costs rise or demand for products and services increases faster than supply. Inflation can happen in many different ways. All of these causes are usually categorized into three main types of inflation.
Cost-push inflation occurs when prices rise due to the increase in the cost of raw materials.
If the cost of creating a product or providing a service is higher, companies will pass that cost on to consumers by raising the price of those products and services.
Prices rise when the demand for goods and services increases faster than the supply.
If people want to buy something with a limited supply, they’ll be willing to pay more for it, and companies will charge higher costs for the same product or service.
Workers want higher wages to keep up with the cost of living.
When prices rise due to cost-push or demand-pull, people expect higher wages in order to keep their lifestyle and standard of living. Higher wages cause companies to raise the price of their goods and services. This increases the cost of living and causes workers to demand higher wages.
Increase the money supply and inflation
The fact that the government prints money and inflation are correlated with each other.
An increase in the total money supply can lead to cost-push inflation and demand-pull inflation when money is printed out faster than the growth rate of the economy. The money supply is not only cash but also credit, loans, and mortgages.
When central banks lower interest rates, banks will lend at cheaper rates. After that, businesses and individuals borrow more money to spend. That increases demand and results in rising in prices.
If the government cuts taxes, stimulates expenditures, or increases welfare, people will have more money to spend. If the business tax is cut, businesses can raise wages or hire more people. When people have more money, they will spend more, the increased demand increases the price.
When there is more money in circulation, the currency loses value compared to the foreign currency. This makes imported products more expensive because now the domestic currency has poorer purchasing power. The government may also lower the exchange rate to make domestic products more competitive. This will also lead to more expensive imports.
Growth in the money supply only increases demand if the excess money eventually reaches the consumer. For example, in the context of the economic downturn in 2008, interest rates are very low but the lending criteria are very strict. This means that cheap money flows mainly to the rich. The result is the rapid inflation in asset prices (the rich buy stocks and real estate) and inflation for consumer goods is much less.
Who benefits and who suffers from inflation?
Inflation does not affect everyone equally. Some people suffer losses due to falling monetary value while others may benefit from it.
- Debtors – especially if their debts have a fixed interest rate. They pay back their loans in less valuable currency.
- Owners of the land and physical property – These assets tend to keep their value through periods of inflation.
Workers whose wages are calculated according to inflation will not be adversely affected by inflation.
The person who suffered the damage
- Savers – If the inflation rate is higher than interest rates, savings are falling in value.
- Retirees with a fixed income – If you have a fixed pension or interest from investments, your income will not increase with inflation.
- Fixed wage contract workers – If your salary isn’t rising with inflation, that salary is actually going down.
- Borrowers with variable-rate loans – Governments often raise interest rates to make their currency more desirable. That could push up the interest rates of variable-rate loans.
- Fixed-rate lender – If you lend at a fixed rate, you will be returned in less valuable currency.
How to measure inflation
To measure inflation, we will use the inflation index. It is not possible to track the price changes of each product or service in the economy, so the inflation index only tracks the price changes of a small number of goods and services.
Consumer Price Index (CPI)
The most well-known inflation indicator is the Consumer Price Index (CPI). CPI examines the average price of a hypothetical basket of goods and services to see if there is any change in the overall cost of living. The different items in the basket have different weights. These weights reflect the different importance of items in the consumer’s shopping basket. The increase or decrease in the price of all commodities when expressed as a percentage indicates the rate of inflation.
National basket of goods
Each country uses its own method to identify the basket of goods and assign different weights to each item in the basket. People who live in different places will have different daily demands and priorities. The items in the basket change almost every year to better reflect the current needs and desires of consumers.
For example, the main categories in the U.S. cart include Food and beverages, housing, clothing, transportation, medical care, entertainment, education, and other goods and services.
World basket of goods
Each basket is usually sorted by the main categories above, and in most countries, the items in those categories are the same.
The inflation factor is calculated in percentage terms and divided into 4 levels as follows:
Creeping inflation occurs when the inflation rate rises to 3% per year.
This is a good condition for economic growth as it motivates consumers to buy in the present and avoid higher prices in the future. That drives demand while production and wages have enough time to keep up.
That’s when inflation remains in the single digits, between 3% and 10% and lasts for a long time.
Inflation often becomes a disturbing issue when it exceeds 4%. This type of inflation affects negatively on the economy because consumers start buying more than their demand to avoid higher prices in the future. When that happens, production and wages can’t keep up. Manufacturers will raise prices due to higher demand. However, wages are not rising, people will not be able to afford to buy some goods and services.
This is when the inflation rate rises above 10%.
At this rate, inflation becomes a serious and difficult problem to control. Money depreciated at such a rapid rate that wages had no chance of keeping up with prices. It has adverse effects on the population of a country, especially the poor and middle class. To control galloping inflation, countries need to adopt strong fiscal and monetary measures.
When inflation reaches 50% a month (above 1000% a year), it is called hyperinflation.
This is the most extreme form of inflation and only 58 hyperinflations in history have been recorded. Prices go up several times a day – something that costs $10 in the morning can cost $100 in the afternoon.
Money is becoming worthless at such a rate that the government has to print money in increasingly large denominations. You may have to pay $150 billion for a loaf of bread…
Prices rise at a rapid rate, so people start hoarding goods which leads to a shortage of goods and services. In most cases, people will face severe food shortages.
Savings, investments, and pensions become worthless as the purchasing power of the currency decreases. People stop using banks leading to banks and other lenders stopping doing business. The collapse of the entire monetary system is inevitable.
Inflation has a great impact on the financial market in particular and the economy and society in general. Therefore, investors need to predict market trends and measure inflation to seize opportunities and make informed decisions.