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| What is Inflation ( photo: NIESR ) |
Although it is simple to track the price fluctuations of individual products over time, human necessities go beyond just one or two items. People require a diverse range of products and services to live a comfortable life, such as food grains, metals, fuel, utilities like electricity and transportation, and services like healthcare, entertainment, and labor.
Inflation serves to quantify the collective impact of price changes for a varied set of products and services. It provides a singular value that represents the overall increase in the price level of goods and services in an economy over a specific time frame.
When prices increase, the value of money decreases, resulting in a situation where one unit of currency can purchase fewer goods and services. This decrease in purchasing power affects the cost of living for the general public and can ultimately hinder economic growth. The prevailing opinion among economists is that continuous inflation arises when the growth of a country's money supply exceeds its economic growth.
In order to address this issue, the monetary authority, usually the central bank, takes necessary actions to regulate the money supply and credit to maintain inflation within acceptable levels and ensure a smooth running economy.
Monetarism is a widely accepted theory that explains the relationship between inflation and the money supply of an economy. For instance, following the Spanish conquest of the Aztec and Inca empires, a significant amount of gold and silver flowed into the Spanish and European economies, leading to a rapid increase in the money supply and a subsequent decline in the value of money, which contributed to the steep rise in prices.
Inflation can be calculated using various methods depending on the types of goods and services. It is the opposite of deflation, which refers to a general decrease in prices when the inflation rate falls below 0%. However, it's important to note that deflation should not be mistaken for disinflation, which refers to a reduction in the rate of inflation.
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Causes of Inflation
The root cause of inflation is an increase in the money supply, although this can manifest in different ways within the economy. The monetary authorities can boost a country's money supply through various means, such as printing and distributing more money to citizens, legally lowering the value of the legal tender currency, or loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market (which is the most common method). Regardless of the method used, the value of the money ultimately diminishes, leading to a loss of purchasing power.
The effects of this decrease in purchasing power can result in three types of inflation: demand-pull inflation, cost-push inflation, and built-in inflation. These mechanisms operate in distinct ways and can be used to classify the impact of the inflationary pressure.
- Demand-Pull Effect
Demand-pull inflation happens when the supply of money and credit increases, causing an overall surge in demand for goods and services at a faster pace than the economy's production capacity. This heightened demand leads to an increase in prices.
With more money in their pockets, people tend to have a more positive outlook on consumption. This optimism translates to increased spending, thereby driving up prices. As demand outstrips supply due to a less flexible supply chain, a demand-supply gap is created, resulting in higher prices.
- Cost-Push Effect
Cost-push inflation occurs as a consequence of rising prices affecting the input processes in production. An increase in the supply of money and credit channeled into commodity or other asset markets leads to a rise in the costs of intermediate goods. This effect becomes more apparent when there's a negative economic shock that affects the supply of essential commodities.
As a result, the finished product or service becomes more expensive, leading to an increase in consumer prices. For example, if the money supply is expanded, it can lead to a speculative boom in oil prices. This, in turn, can lead to a rise in energy costs, contributing to an increase in consumer prices, which can be measured through various inflation metrics.
- Built-in Inflation
Built-in inflation is closely tied to the concept of adaptive expectations, whereby people expect that current inflation rates will persist in the future. As prices of goods and services rise, people may expect a similar rise in the future, leading workers to demand higher wages to maintain their standard of living. This, in turn, results in an increase in the cost of goods and services, perpetuating a wage-price spiral where each factor influences the other in a continuous feedback loop.
Types of Price Indexes
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Multiple types of price indexes are calculated and tracked depending on the selected set of goods and services used. The two most commonly used price indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
- The Consumer Price Index (CPI)
The Consumer Price Index (CPI) is a measurement that evaluates the average price of a basket of goods and services that are essential to consumers, such as food, transportation, and medical care.
To calculate the CPI, price changes for each item in the predetermined basket of goods are taken into consideration and then averaged based on their relative weight in the whole basket. The prices used for the calculation are the retail prices of each item, as available for purchase by individual consumers.
Changes in the CPI are utilized to determine price variations related to the cost of living, making it one of the most commonly used statistics for identifying periods of inflation or deflation. The Bureau of Labor Statistics (BLS) in the United States reports the CPI on a monthly basis and has been calculating it since 1913. The CPI-U, introduced in 1978, represents the buying habits of about 88% of the non-institutional population in the United States.
- The Wholesale Price Index (WPI)
The Wholesale Price Index (WPI) is a widely used measure of inflation that tracks changes in the price of goods at the wholesale or producer level, before they reach the retail level. The items included in the WPI may differ from country to country, but typically include items at the producer or wholesale level. For example, it may include raw materials such as cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing.
While many countries and organizations use the WPI, some countries like the United States use a similar variant called the Producer Price Index (PPI).
- The Producer Price Index (PPI)
The Producer Price Index (PPI) is a group of indexes that track the average change in prices received by domestic producers for intermediate goods and services over time. Unlike the CPI, which measures price changes from the perspective of the buyer, the PPI measures price changes from the seller's point of view. It is possible that the increase in the price of one component, such as oil, may partially offset the price decrease in another component, such as wheat. The PPI provides the average weighted price change for the given constituents, which may apply to the overall economy, sector, or commodity level.
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The Formula for Measuring Inflation
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The formula for measuring inflation can be expressed as:
Inflation Rate = [(Price Index in Current Period - Price Index in Previous Period) / Price Index in Previous Period] x 100
The price index can be any of the CPI, WPI, or PPI, depending on the type of inflation being measured. The formula calculates the percentage change in the price index between two periods, which gives the inflation rate.
For example, if the CPI in January is 120 and in February it is 124, then the inflation rate between January and February would be:
[(124 - 120) / 120] x 100 = 3.33%
This means that the cost of living, as measured by the CPI, increased by 3.33% between January and February.
Advantages and disadvantages of inflation
Can be interpreted in different ways depending on one's perspective and the rate at which inflation occurs.
- Advantages:
Some individuals who own tangible assets such as property or stocked commodities priced in their home currency may benefit from inflation as it increases the price of their assets, allowing them to sell them at a higher rate.
Inflation can also lead to speculation among businesses and individuals. Businesses may take on riskier projects, while individuals may invest in stocks with the expectation of better returns than inflation.
An optimal level of inflation is often promoted to encourage spending to a certain extent instead of saving. When the purchasing power of money decreases over time, there may be a greater incentive to spend money now instead of saving it for later. This can increase spending, which in turn may boost economic activity in a country. A balanced approach is often sought to maintain inflation within an optimal and desirable range.
- Disadvantages:
1. Reduced purchasing power: Inflation can lead to a reduction in the purchasing power of money, as prices for goods and services increase. This can impact individuals on a fixed income, as they are not able to keep up with the rising prices.
2. Uncertainty: Inflation can create uncertainty in the economy, making it difficult for businesses and individuals to plan for the future. This can lead to a decrease in investment and economic growth.
3. Decreased savings: Inflation can lead to a decrease in the value of savings, as the purchasing power of money decreases. This can impact individuals who rely on their savings for retirement or emergencies.
4. Wage-price spiral: Inflation can lead to a wage-price spiral, where workers demand higher wages to keep up with rising prices, and businesses raise prices to cover the increased labor costs. This cycle can lead to further inflation and economic instability.
5. International competitiveness: High levels of inflation can make exports more expensive and reduce a country's international competitiveness, as other countries may be able to produce goods and services at a lower cost.
Pros:
- Increases the resale value of tangible assets
- Encourages spending at optimum levels of inflation
Cons:
- Increases the cost of products and services for buyers
- Imposes higher prices on the economy
- Drives up certain prices before others, creating distortions in relative prices
Controlling Inflation
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The responsibility of controlling inflation lies with the financial regulator of a country. The regulator achieves this by implementing measures through monetary policy. This refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.
In the United States, the Federal Reserve (the Fed) has the goal of moderate long-term interest rates, price stability, and maximum employment through its monetary policy. These goals aim to promote a stable financial environment. The Federal Reserve communicates its long-term inflation goals clearly to maintain a steady rate of inflation that is deemed beneficial for the economy.
In times of extreme economic conditions, monetary authorities may resort to exceptional measures. For example, after the 2008 financial crisis, the U.S. Fed kept interest rates near zero and implemented a bond-buying program known as quantitative easing (QE).
Critics of the program claimed that it would cause a surge in inflation in the U.S. dollar. However, inflation reached its peak in 2007 and gradually declined over the next eight years. The reasons why QE did not result in inflation or hyperinflation are complex, but the simplest explanation is that the recession itself was a significant deflationary environment, and quantitative easing helped to mitigate its effects.
As a result, policymakers in the United States have aimed to maintain a stable inflation rate of approximately 2% per year. Similarly, the European Central Bank (ECB) has pursued aggressive quantitative easing in response to deflationary pressures in the eurozone, and some regions have experienced negative interest rates. This is due to concerns that deflation could take hold in the eurozone and lead to economic stagnation.
Furthermore, countries with higher economic growth rates may be able to tolerate higher inflation rates. For instance, India has a target inflation rate of around 4% (with an upper tolerance of 6% and a lower tolerance of 2%), while Brazil aims for an inflation rate of 3.5% (with an upper tolerance of 5% and a lower tolerance of 2%).
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Hedging Against Inflation
To protect against the effects of inflation, investors can use a variety of strategies. Stocks are considered to be a good hedge against inflation since the rise in stock prices already reflects the effects of inflation. As new money is added to the economy, it tends to have an immediate effect on the prices of financial assets that are priced in the home currency, such as stocks.
There are also financial instruments that can be used to protect investments against inflation. One example is Treasury Inflation-Protected Securities (TIPS), which are low-risk treasury securities that are indexed to inflation. The principal amount invested in TIPS is adjusted by the percentage of inflation, thereby protecting the investor from the eroding effects of inflation.
Investors can also choose to invest in TIPS mutual funds or TIPS-based exchange-traded funds (ETFs) as additional options for hedging against inflation. In order to access stocks, ETFs, and other funds that can help protect against the risks of inflation, an investor will typically need to open a brokerage account. Selecting a stockbroker can be a challenging process due to the differences between them.
In addition to stocks, gold is often regarded as a hedge against inflation, but this has not always been evident in the past.
Extreme Examples of Inflation
All global currencies are fiat money, which means that the money supply can increase rapidly for political reasons, leading to a rapid increase in price levels. The most well-known instance of this is the hyperinflation that hit the Weimar Republic of Germany in the early 1920s.
Following World War I, the victorious nations demanded reparations from Germany, which couldn't be paid in German paper currency since it was of questionable worth due to government borrowing. Germany attempted to print paper notes, buy foreign currency with them, and utilize that foreign currency to pay off their debts.
The policy of printing paper notes to buy foreign currency led to the rapid devaluation of the German mark, resulting in hyperinflation. To counter this, German consumers tried to spend their money as quickly as possible, as they knew that its value would continue to decrease. As a result, more money was introduced into the economy, causing its value to plummet. The bills became almost worthless, and people started using them to paper their walls. Peru experienced a similar situation in 1990, while Zimbabwe faced hyperinflation between 2007 and 2008.
What Causes Inflation?
There are three primary causes of inflation: demand-pull inflation, cost-push inflation, and built-in inflation.
Demand-pull inflation occurs when there is a shortage of products or services relative to the demand for them, resulting in price increases.
Cost-push inflation, on the other hand, occurs when the cost of producing goods and services increases, forcing businesses to increase their prices.
Built-in inflation, also known as wage-price spiral, is when workers demand higher wages to keep up with the rising cost of living. This leads businesses to increase their prices to offset the higher wage costs, resulting in a self-perpetuating cycle of wage and price increases.
Is Inflation Good or Bad?
In general, excessive inflation is considered detrimental to an economy, while insufficient inflation can also be harmful. Economists typically recommend a moderate level of inflation, typically around 2% per year.
Savers are generally adversely affected by higher inflation since it diminishes the purchasing power of their savings. On the other hand, borrowers may benefit as the inflation-adjusted value of their outstanding debts decreases over time.
What Are the Effects of Inflation?
Inflation can have various effects on the economy. For instance, if inflation results in a decline in a nation's currency, it can benefit exporters as their goods become more affordable in foreign currencies. However, this could be detrimental to importers as it increases the cost of foreign-made goods. Additionally, high inflation can prompt increased spending, as consumers rush to purchase goods before their prices increase further. Conversely, savers may witness the actual value of their savings diminish, potentially limiting their future spending or investment options.
Why Is Inflation So High Right Now?
In 2022, inflation rates worldwide, including in the U.S., surged to levels not seen since the early 1980s. The exact cause of this rapid rise in global prices is multifaceted, with several factors working together to push inflation to such high levels.
The COVID-19 pandemic, which started in early 2020, led to lockdowns and other measures that severely disrupted global supply chains, causing bottlenecks at ports and factory closures. Governments responded by issuing stimulus checks and raising unemployment benefits to help individuals and small businesses financially impacted by these measures. When the economy rebounded quickly due to widespread COVID-19 vaccinations and low interest rates, demand (aided in part by stimulus money) outstripped supply, which was still struggling to return to pre-pandemic levels.
Russia's unprovoked invasion of Ukraine in early 2022 resulted in economic sanctions and trade restrictions on Russia, limiting the world's supply of oil and gas since Russia is a significant producer of fossil fuels. At the same time, food prices increased as Ukraine's substantial grain harvests could not be exported. As fuel and food prices rose, it caused similar price increases down the value chains.
The Bottom Line
Inflation is the increase in prices over time, leading to a decrease in purchasing power. Although the U.S. government aims for an annual inflation rate of 2%, too much inflation too quickly can be harmful. Inflation causes goods and services to become more expensive, particularly if wages don't increase at the same rate as inflation. It also diminishes the value of some assets, particularly cash. Governments and central banks attempt to manage inflation through monetary policies.
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source: https://www.investopedia.com
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