TL:DR
Inflation is topic tha tmost people may not understand its root cause. We can take inflation to be a particular set of items that might be different for different people. For instance, if your life consist of Netflic, McDonalds, and buying clothes in ZARA, then your inflation rate would be at the rate of which those prices rise.
The one inflation rate we care about is the monetary one. That is the rate at which the government prints dollars. Further, other factors contribute to this, for instance, if the government decides to print more dollars but the amount of goods and services produced in one's economy stays the same or goes down, then prices will see an increase.
Inflation affects everyone. In the U.S economy, inflation will cause the dollar to depreciate in value casuing everything to become expensive. As a result, saving money in a bank account will drastacillay reduce your purchasing power. Their are metrics in place that a government employs through their central bank, in order to reduce spending and inflation.
Introduction
Inflation is defined as the lose of purchasing power of any given currency. However, inflation could mean different things for different industries. In one's economy it could mean the sustained price increase for the services and goods produced. In other words, the rate at which prices increase.
In this sense, the prices of multiple goods and services in a given economy will increase. This increase is long-term, in other words, the prices of these goods and services increase for a long period of time not just short term sporadic events.
Our goal in this post is to have a better understand of inflation, where it comes from, and ways to fight it off.
What Causes Inflation?
Generally speaking, when discussing inflation there is usually a common cause. This cause is the rapid increase in the amount of fiat currency in circulation in an economy. Take the recent money injection into the U.S economy as an example. In 2020, due to the shutdowns, the U.S had to inject money into the economy in order to prevent a recesion due to low economic activity. As a result, it printed 33% of the entire money supply. The result, inlfation across the board.
The second most popular cause of inflatoin is a supply shortage. This supply shortage in a good that is high in demand can spark a rupple affect through the rest of the economy casuing other things to increase in price. Take the recent events with Oil prices. The increase of oil prices was due to the lack of supply. The shortage first appeared after Covid-19 due to the lack or production during the pandemic. After the pandemic ended the demanded rose to pre-covid levels, but the supply or at least the production of Oil wasn't on part with the demand. As a result, Oil prices increased, which causes goods to increase as well since they need to be transported from place to place.
Despite these, if we conceptualize it and peel back the layers, we can classify inflation in the following three categories, demand-pull inflation, cost-push inflation, and built-in inflation.
Demand-Pull Inflation
When there is an increase in the supply of money, it stimulates the demand for overall goods and services in the economy. This demand, however, rises more rapidly than the economy's production of goods and services. Prices rise when demand increases but supply stagnates or decreases. This is called demand-pull inflation.
The availability of more money to individuals leads to a more positive consumer sentiment, which leads to higher spending. Prices rise as a result. Consequently, it creates a demand-supply gap, where demand is much higher but supply is much lower. As a result, prices rise.
Cost-Push Inflation
Cost-push inflation results from the price levels rising due to the increase of raw material and production costs. Consequently, the costs are pushed to the consumer.
Whenever there is an increase to the supply of money, those are channeled into the commodities or other asset markets. The result is an increase of prices of those commodities and assets. These costs make there way up to the consumer, who ends up paying higher for a finished product.
Built-In Inflation
Adaptive expectations, which assume of future inflation rates similar to those currently in place, cause inflation to be built into the economy. When goods and services become scarcer, they become more expensive, which makes people and corporations expect that prices will rise at the same rate in the future. Increasing wages lead to a price increase in consumer goods, and the spiral continues as one factor triggers the other.
HyperInflation
Runaway inflation is typically hyperinflation. Hyperinflation in that sense is excessive and out of control prices in the economy. It is typically measured to be an increase of prices of more than 50% a month. For comparison, inflation as measured by the CPI is typically anywhere between 2-5% a month in the U.S.
While it is a rare phenomenon in developed countries, there are many hyperinflation examples that have occured throughout history. Some of the popular countries has been in China, Germany, Hungary, and most recently Venezuela. While inflation is typically measured on a monthly basis, hyperinflation could be measured on a daily basis where in flation can hit anywhere between 5-10% a day.
What causes HyperInflation?
While Inflation can be caused by a number of reasons but one of the more common ones is listed below:
Excessive Money Printing
Typically, hyperinflation occurs in sever economic turmoil and depression. Depression is classified as a period of time of negative growth that occurs for many years. It can last years and there could also be extremely high unemployment, bankruptcies, and lower production output. As a result, the country response is to issue more money through the central bank. The extra money is designed to encourage banks to lend and people to spend.
This is an issue, however, if there is no economic growth measured by a countries gross domestic product (GDP). The end result for this could be hyperinflation. This is because if the production of goods and services stay stagnant or even decrease but there is an excess supply of money, then businesses will raise prices to stay afloat. Since retailers and institutions have more money, they are willing to pay the higher prices. Since there is no economic growth, companies charge higher prices for the goods, consumers end up paying more and the central bank contains this vicious cycle of hyperinflation by printing more money.
Example
One popular example is Germany and the Mark. In an effort to fund the war, Germany depegged the Mark from gold. It basically took it off the gold standard. As a result, the Germans printed excess money with nothing to back it up. After the war finished, they also had to pay reparations which lead to even more money being printed. The end result, hyperinflation.
Controlling Inflation
There are mechanisms in place that aid in controlling or at least remedying the affects of inflation. If the inflation is left unchecked it could cause hyperinflation, which we explain down below. Therefore, governments have in place these mechanism to curb or at least control inflation in the economy. The governments do this through monetary and fiscal policy.
In the U.S, the Federal Reserve (which is the central bank for the United States) has the power to increase or decrease the supply of money in criculation. There are things the Central Bank can do to reduce inflation such as raising interest rates.
Higher Interest Rates
Borrowing money becomes more expensive at higher interest rates. Businesses and consumers shy away from credit in response. Consumer expenditures will be discouraged by increased interest rates, resulting in a decline in demand for goods and services. During this time, it becomes more attractive to lend money in order to earn these higher interest and even more so, it becomes an option to save.
There are some effects to this, one of them being a lack for economic growth. This is due to the lack of borrowing due to the high price to borrow money. Therefore, there are less participants willing to borrow money to invest or spend.
Fiscal Policy
Fiscal policy refers to the government's spending and influence of taxes. One of the waves it can help ease inflation is by the lack of spending. However, this may seem less favorable as the cuts usually lead the public to express their opinion against it. In addition, the government could also increase taxes, which will reduce spending since the taxpayer has less money. Again, this will also meet a resistance as the general population would react differently and negatively to higher taxes.
Inflation Measured Through A Price Index
One of the ways to determine whether inflation exists in the current economy is through a price index. This is one way to measure the level of inflation. This is done by observing the price of an index over a period of time. Many governments use the Consumer-Price-Index (CPI) to determine inflation. Another measure they take into account as well is the Weighted-Price-Index (WPI) and Producer Price Index (PPI).
Consumer Price Index (CPI)
A CPI provides an up-to-date measure of changes in the price level of consumer goods and services purchased by households (or people in a household or other collective living situation).
The Consumer Price Index (CPI) is a measurement of the average change over time in prices paid by consumers for a market basket of consumer goods and services. The CPI is certainly not without controversy, but it has been used for decades to calculate changes in the cost-of-living.
The Bureau of Labor Statistics releases a monthly report on the CPI and has calculated it since 1913. The CPI represents an average price paid by consumers for a bundle of goods and services.
Wholesale Price Index (WPI)
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods at the producer level. It includes items like cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing.
Producer Price Index (PPI)
The producer price index (PPI), a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. It differs from the consumer price index (CPI), which measures price changes from the perspective of the buyer.
Formula To Measure Inflation
Inflation can be calculated in different ways, depending on the type of CPI that is used. For example, inflation can be calculated by simply taking the price difference between two months or years. Mathematically,
Percent inflation rate = (Final CPI Index Value/Initial CPI Value)*100
As an example, lets suppose that we want to calculate the change of purchasing power of $100,000 between April 2012 and April 2022. The CPI for April 2012 was at 230.085. In April 2022 the CPI was at 289.109. Plugging these numbers into our formula we get:
Percent inflation rate = (289.109/230.085)*100=125.653%
Since our goal is to know how much those $100,000 are worth in 2022, we need to multiply those $100,000 by the percent inflation rate. Therefore,
Change In Dollar Value=1.25653*100,000=$125,653
This means that $100k in April 2012 would be worth $125k+ in 2022. So essentially, if you were to buy a basket of goods and services that cost $100k in 2012, then in order to buy the same basket of goods and services, you would need to have $125k.
Pros of Inflation
When discusing and learning about inflation, one thing that may come to mind is that it is better to avoid it altogether. However, inflation remains an important aspect for any growing economy. Lets discuss some advantages:
Increased Spending, Investment and Borrowing
Our previous discussion indicated that a low rate of inflation can be beneficial to the economy by encouraging spending, investment, and borrowing. As inflation makes it difficult to aquire the same amount of goods as before, there is an incentive to aquire goods and services immediately.
Higher Profits
In order for companies to stay afloat in a inflationary period, they need to raise the prices of their goods or services. They often do this and raise a bit more to increase any profits but justify the increase due to inflation.
Cons of Inflation
There is also downsides for a country that is experiencing inflation. Some of the more common ones are listed below.
Currency Devaluation
Printing all that money will inevitable cause the fiat currency to become worthless. As an example think of LUNA, the crypto coin. Before it has its major collapse, there were about 700 million coins in circulatioin. Soon after it started to mint new tokens, it reached a high 6 trillion causing the coin to tank in value. The same thing happend to any fiat currency whenever there is excess printing. The value of that currency decreases causing lower purchasing power.
Hyperinflation
Periods of high inflation is known as hyperinflation. As described above, hyperinflation usually results in price increase of more than 50%. Saving or storing money in your bank account or underneath your mattress is not ideal in periods of hyperinflation. It won't have the same purchasing power in the future.
Hyperinflation can also destroy the currency and trust within the country. It essentially destroys the economy of the country.
Final Thoughts
The causes of inflation are such that a countries currency is affected. Likewise, an economy could also feel the affects causing inviduals to lose confidence and trust in the fiat currency.
This phenomenon will cause prices to increase over a period of time that could be beneficial if controlled properly. However, if left unchecked the opposite could occure which will result in hyperinflation thus, destroying an economy.
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