Inflation is a term that gets tossed around a lot in economic discussions, but what exactly does it mean?
Simply put, it refers to the general increase in prices for goods and services over time. As this happens, the purchasing power of a currency falls because you need more money to buy the same items.
High inflation tends to erode people’s standard of living as the cost of everyday expenses like food, housing, and transportation go up. Other effects of high inflation include difficulty budgeting and planning long-term since inflation makes the future cost of items uncertain.
Savers also suffer as the value of their savings declines relative to the increasing prices. Therefore, keeping inflation low and stable is a key goal for the central bank and government.
Understanding Inflation and its Effects
Understanding it is crucial for consumers and investors. Why? It will help you to know when it can occur, how it affects your investments or spending, and how you can soar over its fangs. This way, you can make sound financial decisions.
What Causes Inflation to Occur?
Inflation seems like a straightforward concept – prices go up over time. But numerous factors actually drive inflation rather than one single cause. At a basic level, when consumer demand for goods and services increases faster than supply, suppliers will raise prices to balance things out. This is usually referred to as the demand-pull inflation.
In other words, if disposable income among consumers rises rapidly, perhaps due to government stimulus programs, demand tends to rise. This is because people have more money to spend.
There is also built-in inflation, which happens when businesses and suppliers raise prices in anticipation of future economic changes. Typically, during such periods, people expect the trend to continue and demand higher wages to keep up with the rising cost of living.
Increased wages lead to higher production costs for goods and services, which only leads to increased inflation.
Another cause of price increases is the cost-push effect, which occurs when the rising cost of raw materials and wages drives up overall expenses. When production costs increase, the supply of goods and services may decline. However, if demand remains unchanged, prices rise as demand exceeds supply, leading to this economic effect.
How to Measure Inflation
The most common is the Consumer Price Index (CPI). The CPI looks at a basket of retail products and services households regularly purchase, including food, medical care, housing costs, transportation, recreation, and education. It then tracks how the total cost of that basket changes over time.
CPI provides the most widely recognized indicator of inflation. The percentage change in CPI leads to what is referred to as consumer price inflation.
Besides CPI, there is also the Producer Price Index (PPI). This one measures inflation from the producer/wholesaler perspective rather than the consumer. The PPI tracks changes in wholesale prices reported by domestic producers of goods and services.
Another metric is the Wholesale Price Index (WPI). The WPI measures the average price changes at the first commercial transaction level, which means it tracks and measures price changes for goods and services before the retail level.
WPI items usually include wholesale or producer prices, such as cotton prices for cotton clothing, raw cotton, or cotton gray goods. However, a different metric is used in the US, known as the PPI (producer price index).
While similar to the WPI, the PPI uses price changes from the seller’s perspective, instead of that of a buyer, to calculate inflation. It measures the average price change in selling prices of goods and services received by domestic producers.
What are the Effects of Inflation in an Economy?
As indicated earlier, inflation is the gradual rise in the general price level of goods and services that affects individuals, businesses, and economies at large.
One of the most undeniable effects of inflation is the erosion of purchasing power. As prices climb, each unit of currency buys fewer goods and services. This reduction in real income can be particularly challenging for fixed-income individuals, such as retirees living on pensions. Additionally, savers witness a decrease in the value of their savings over time.
Inflation also introduces an element of uncertainty into the economy. Businesses find it challenging to plan for the future as fluctuating prices impact production costs and profit margins. Conversely, consumers may delay purchases in anticipation of lower future prices, leading to a slowdown in economic activity.
Income redistribution is another consequential outcome of inflation. As the cost of living rises, workers often negotiate higher wages to maintain their standard of living. However, this can result in a cycle where businesses pass on increased labor costs to consumers through higher prices, creating a perpetual loop of inflationary pressure.
However, while inflation has more negative implications, it’s important to acknowledge its positive aspects. For instance, moderate inflation can stimulate spending and investment. This happens as consumers and businesses are incentivized to act rather than hoard cash. Additionally, inflation can provide debt relief, as the real value of debts tends to decrease over time.
How to Deal with Inflation
With high inflation causing increased costs of living and economic uncertainty, getting it under control is a priority for policymakers. Luckily, there are several approaches they can take to reign in excessive inflation.
One way is to raise interest rates. This makes borrowing and spending more expensive. Subsequently, when people and businesses pull back on spending, demand starts to ease, and prices stabilize.
Central banks increasing reserve requirements, so banks have less money to lend, is another monetary policy lever. Less lending means less money to the borrowers or consumers, leading to less spending.
On the fiscal side, governments can reduce public spending to control demand. When less government money flows into the economy, the spending power for citizens also goes down. Taxes could potentially be increased to achieve a similar dampening effect on demand.
Paying down public debt and avoiding printing excessive money are also inflation-fighting tactics. Better still, policymakers can indirectly encourage supply growth by subsidizing producers, removing regulations or tariffs, and stimulating employment. The idea is to align demand and supply.
There’s no quick fix, generally. However, prudent use of monetary and fiscal policies can be effective in curbing inflation over time.
