What does inflation mean?

The term “Inflation” refers to the macroeconomic phenomenon of progressive decrease in the purchasing power of a given currency over time – but why does inflation occur, what exactly are the causes of inflation, and what are the effects of inflation on the economy? 

What is inflation?

Inflation is the rate of decrease of the value of a currency, which results in a general increase in the prices of goods and services.

What causes inflation?

Inflation stems from an increase in the amount of money in circulation in the economy, but can be expressed and experienced in different ways. Fluctuation in the supply of money in circulation in the economy is influenced by monetary authorities through printing more money, giving away money to individuals, purposely devaluing the currency, or by loaning new money into existence as credits to national bank reserves, buying back government bonds. Through each of these examples, the effect is a decrease in the purchasing power of the currency. But what causes inflation to rise over time? The answer to that derives from these mechanisms:

Demand-Pull Effect

Demand-pull inflation occurs when an increase in the supply of money in circulation leads to greater demand for goods and services at a rate that exceeds the economy’s production capacity. As a result, the increased demand leads to an increase in prices. 

With more money to spend, there is an increase in consumer sentiment, which leads to more spending. This increase in demand creates a gap in supply and leads to a higher price point equilibrium.

Cost-Push Effect

Cost-push inflation refers to inflation that stems from increases in the prices of production process inputs. This usually occurs following a shock to the economy, which is responded to with an influx of money channeled into the economy toward a specific type of commodity, causing an increase in costs for intermediate goods. This inadvertently leads to higher costs for the final consumer, permeating to other types of products or services. 

Built-in Inflation

Built-in inflation refers to the increase in the cost of goods and services that occurs when workers come to expect prices of goods and services to increase in the future, and demand higher wages. Consequently, the increase in worker wages contributes to the increase in the costs of goods and services. This wage-price relationship continues indefinitely as the one side stokes the other.

How is inflation measured?

Inflation is measured and monitored over time by national and international monetary agencies, such as the European Central Bank or Federal Reserve, deciding different price indices to use to develop, promote and implement monetary policies in order to keep inflation at manageable rates. 

Types of Price Indexes

When deciding how to calculate inflation, different price indexes may be consulted. The price indexes that are most commonly referred to in economics are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

Consumer Price Index (CPI): The CPI measures the weighted average of prices of a selection of basic goods and services, often referred to as a “basket of goods”, which include things like transportation, food, and healthcare. By averaging retail price changes for these goods and services, and weighing the individual averages in relation to those of other goods and services analysed, the CPI can be used to assess changes in the prices most closely associated with the cost of living, and is commonly used to assess changes in the cost of living during periods of accentuated inflation.

The Wholesale Price Index (WPI): The WPI is another index used to measure the changes in the price of goods behind the retail price. This index is more commonly used to address changes in the prices of raw materials and services provided in production.

The Producer Price Index (PPI): The producer price index refers to the measurement of the average change in the prices provided by producers of a selection of goods and services over time. As opposed to the CPI, the PPI establishes the trend in average price variation from the point of view of the seller rather than the buyer. 

In each of the indices mentioned above, an increase in price of one good or service may compensate for decline in the price of another, for which the composite indices may be considered to be representative for the overall economy. 

How is inflation controlled?

When looking at how inflation is controlled, one of the main tools that financial regulators have in controlling inflation is through the implementation of monetary policies that promote financial stability. This can be achieved through controlling long-term interest rates and price stability, since these provide stable parameters for businesses to plan for the future, as well as directly governing the amount of money in circulation.

In extreme cases, such as the financial crisis of 2008 or during the Covid-19 pandemic of 2020, monetary authorities take more extreme measures to provide stability, such as lowering interest rates to near zero percent.

What Are the Effects of Inflation?

While inflation causes the strength of a currency to decline, for some actors in the economy, inflation may actually be beneficial. For example, pricing for imported goods and services may become increasingly convenient for exporting companies, as the price point equilibrium rises. 

Inflation also tends to encourage spending, as consumers move to purchase goods and services while they are still priced at rates that are less expensive, while money that is left in savings steadily loses its value.

How to beat inflation with investments?

One way to hedge against the risk of losing wealth from inflation is to invest money in stocks, since the rise in stock prices also accounts for market inflation. Investing in inflation-protected mutual funds or exchange-traded funds also provides protection against inflation.

Pros and Cons of Inflation

Those with assets like property or stock investments may appreciate some inflation, as it causes the price of their assets to increase, meaning that they can generally sell them at higher rates than those at which they bought them. Companies can also benefit from inflation if pulled by demand, as they are able to charge more for their products and increase margins. Asset buyers, on the other hand, or those whose assets are held in cash or cash equivalents are negatively impacted by inflation, since it diminishes the value of the assets they need to use to pay for the assets. Businesses can also be adversely impacted by inflation if driven by an increase in production costs and they are unable to transfer the cost of products onto consumers (i.e. if customers are not willing to bear the increased costs of goods or services).

Consequently, as the purchasing power of money decreases over time, inflation promotes spending as opposed to saving, thereby boosting the economy. That is why most countries seek to strike a balanced approach to inflation, attempting to keep it at a desirable rate.

However, when inflation rates are too high and variable, it causes more harm than good to the economy, incurring major costs that must be accounted for by businesses, workers and consumers alike, as rising prices affect current and future decisions for buying and selling. Though even when the inflation rate is low and stable, if the introduction of new money into the economy is managed improperly, it can distort wages and returns on investments while driving up prices.