What’s it: The inflation rate is the percentage change in the economy’s prices of goods and services over a certain period. While inflation tells us about a situation where the prices of goods and services increase or decrease, the inflation rate tells us what percentage of the increase or decrease.
Inflation applies to the aggregate prices of goods and services. So, for example, if the price of an item increases, it is not inflation. Instead, when inflation occurs, the prices of almost all goods and services in the economy increase.
Why is inflation important in the economy?
Inflation is one of the most widely observed economic indicators in addition to economic growth, exchange rates, and interest rates. For example, the central bank observes its trend to take monetary policy.
In general, inflation erodes the purchasing power of money. When it is high, we have to spend more money to get the same item. Take a simplified example. We have to spend $1 to get an item. However, as the price goes up, for example, to $2, we have to spend more dollars to get it.
So when there is inflation, a dollar in the past is worth more than a dollar today. This is because we get less stuff today than we did in the past. So, the higher the inflation rate, the less worth the dollar we have.
Inflation is common during economic expansion. During this period, the economy prospered where the unemployment rate was low. As a result, households are optimistic about their income and employment, prompting them to spend more dollars on goods and services. The increase in demand eventually pushes the prices of goods and services to rise.
So, a moderate increase in inflation shows us a growing economy. In this case, inflation is not a problem. On the contrary, it could indicate the economy is prospering.
However, if inflation spikes high, it can be bad for the economy. This is because the dollars we own evaporate in value when we use them to buy goods and services. And its uncontrolled pace – as during hyperinflation – can destroy economic stability. It can disrupt the monetary system, cause political risks and social disaster and hinder investment in these countries. Consequently, people lose faith in the domestic currency. You can delve into what’s happening in Venezuela, for example.
Some countries target inflation as the anchor of their policies. They set limits on acceptable inflation rates. For example, in the United States, the central bank targets inflation at around 2%. If it is higher or lower, the central bank will intervene in the economy by tightening monetary policy. Everyone believes the central bank will control inflation more stable with this targeting. And for economic actors, stability is important in making economic decisions such as spending and investment.
How do we measure the inflation rate?
If we want to calculate the inflation rate, we must consider all goods and services. And economists then introduce price indexes to make calculations easier. There are three common indices for measuring inflation, namely:
- Consumer price index (CPI)
- Producer price index (PPI)
- GDP Deflator
The price index represents the price trend of a basket of goods and services. How it is calculated will vary in terms of the types of goods and services included and the weight in the calculation. For instance, the consumer price index tracks the prices of goods and services purchased by consumers. Meanwhile, the producer price index tracks the goods and services purchased by producers. And the GDP deflator takes into account all goods and services in the economy, calculated by dividing nominal GDP by real GDP.
The consumer price index is usually the most cited inflation indicator. For example, central banks use it as an anchor to take monetary policy. They then break down the index again and focus on core inflation, namely the consumer price index, without taking into account volatile components such as energy and food.
Now, let’s simulate how to calculate the inflation rate using the consumer price index. How to calculate it? First, we have to get the CPI figures for the current period with the previous period. Second, we divide the current CPI by the previous period’s CPI. Third, we subtract the result by 1 and multiply the result by 100%. Here is the formula for the inflation rate:
- Inflation rate = [(CPI / CPI-1) -1] x 100%
Say the CPI in 2020 is 132. The number rose to 140 in 2021. Applying the above formula, we get an inflation rate of 6.1% = [(140/132) -1] x 100%. It shows that, in general, the prices of goods and services purchased by consumers rose 6.1% throughout 2021.
What are the types of inflation? What caused it?
An increase in the price of goods and services can occur due to supply or demand problems. Alternatively, it may also occur due to an expectation issue, which causes the price to lead to the expected trend. For example, when we expect the price of goods to rise in the next month, we will decide to shop now before paying more in the next month. Eventually, our demand goes up and causes the price to actually go up.
And in general, economists divide inflation into three categories based on its causes. They are:
- Cost-push inflation
- Demand-pull inflation
- Built-in inflation
Demand-pull inflation occurs due to increased demand in the economy. Usually, this type of inflation will follow the economic cycle. It will rise during an economic expansion and decrease during an economic contraction.
During economic expansion, the economy is more prosperous. As a result, households see their income and employment prospects improving, prompting them to increase spending on goods and services. As a result, aggregate demand increases and shifts its curve to the right. This situation creates upward pressure on the prices of goods and services.
In response to increased demand and rising prices, businesses increase their production. And a further increase in aggregate demand will cause the economy to operate above its potential output (positive output gap or inflationary gap).
A positive output gap indicates that domestic production capacity is insufficient to meet aggregate demand. Therefore, the economy must supply it from abroad (imports increase). In addition, businesses face rising production costs due to a tighter labor market. Consequently, they find it difficult to get new, qualified workers without offering higher wages. They then pass the increased costs onto the selling price to maintain profit margins.
The opposite situation occurs during an economic contraction or recession. During this period, aggregate demand decreases. As a result, households see their income and employment prospects deteriorate, forcing them to save more and consume less.
During a recession, the economy operates below its potential output (a negative output gap or contractionary gap). There is downward pressure on the economy’s prices of goods and services. In this situation, the inflation rate may slow down (disinflation), or worse, it may go into negative territory (deflation).
Cost-push inflation occurs due to problems on the supply side. When a shock occurs, supply decreases and increases the price of goods and services. For example, a natural disaster or war can cause a supply-side shock and a sudden supply shortage. Eventually, it pushes up the prices of goods and services.
Another cause of cost-push inflation is rising production costs. An example is an increase in oil prices. Since oil is used in almost every sector, its increase causes production costs to rise from fuel to plastics. This situation then forces businesses to increase their selling price to maintain profitability margins. As a result, the economy’s prices of goods and services creep up.
Due to rising oil prices, inflation spikes occurred in the United States during stagflation in the 1980s. Then, oil prices touched levels above $100 per barrel (in 2019 dollars) and pushed inflation into double digits.
Built-in inflation occurs due to adaptive expectations and a wage-price spiral, creating future inflationary pressures. This inflation forms the core inflation component of the consumer price index.
How do expectations affect inflation? Let’s take a simple example. When we predict the price of goods will rise in the next month, we will tend to shop now. This is because we expect to get the dollar cheaper before the price goes up next month. As a consequence, current demand increases. And it pushed up the price of the item at this time.
Then, as the price trend increases in the next month, we expect prices to rise again, pushing up demand and prices again. This situation continues. So, our expectations – even though the price increase has not yet occurred – cause the price to actually go up.
Built-in inflation also results from the wage-price spiral. During inflation, workers realize their real wages are falling because the prices of goods and services are rising faster than their nominal wages. As a result, their purchasing power decreases. They then demand higher nominal wages to maintain the cost of living and compensate for inflation.
An increase in wages causes production costs to rise. Because wages account for a large part of costs, businesses face declining profit margins. They then pass the increase in nominal wages to the selling price to overcome this situation. As a result, prices rise, and inflation rises higher.
As inflation rose higher, it forced workers to renegotiate higher wages. And rising wages resulted in much higher inflation. This situation continues and creates a wage-price spiral effect.
What are the key terms related to the inflation rate?
When we learn about inflation, we will come across several key terms: deflation, disinflation, reflation, etc. Let’s briefly discuss them.
Deflation is when the price level falls or negative inflation rate (below zero). It usually happens during an economic recession. For example, the inflation rate in the United States was at -0.4% in 2009.
Disinflation occurs when the inflation rate slows down compared to the previous period. This is common during the business cycle and is not harmful to the economy. For example, the inflation rate in the United States slowed from 2.4% in 2018 to 1.8% in 2019 and 1.2% in 2020.
Reflation refers to the first phase of inflation after a period of deflation. For example, during a recession, the government will usually stimulate the economy by increasing the money supply or reducing taxes to bring the economy out of recession. If successful, inflation will usually creep up and out of the negative territory.
Stagflation is when high inflation accompanies stagnant or even declining economic growth. We can break it into “stagnant growth” and “inflation.” It happened in the United States in the 1980s.
Creeping inflation or mild inflation occurs when the inflation rate rises by about 3% or less per year. This situation is considered favorable for economic growth, does not harm the economy, and is close to the central bank’s inflation target (in developed countries, it is usually around 2%).
Walking inflation is a situation when the percentage of inflation is above 3% but below 10% per year. During this period, the economy was deemed overheated, prompting the central bank to adopt a tight monetary policy to moderate it.
Galloping inflation is when inflation is above 10% per year or maybe 50% more but lower than hyperinflation. This situation is dangerous and requires immediate intervention before it leads to hyperinflation.
Hyperinflation is a condition in which inflation spikes and can reach up to 500% in a month. Zimbabwe and Venezuela have recently experienced it. This could be due to a supply shock, war, or regime transition accompanied by upheaval.
How does the government affect the inflation rate?
The government can influence inflation through fiscal policy and monetary policy. The fiscal policy runs through changes to the government’s budget. Meanwhile, monetary policy works through changes in the money supply in the economy.
The two policies are categorized into two based on the objectives. Economic policies to reduce inflation is called contractionary policies. It could be through contractionary fiscal policy or contractionary monetary policy. This policy is usually taken when the economy is overheating and has a high inflation rate. This situation usually occurs in the final phase of economic expansion (called the economic boom).
Meanwhile, policies to encourage economic growth and inflation rates are called expansionary policies. The government can do this through expansionary fiscal policy or expansionary monetary policy. Governments usually carry out this policy to get the economy out of recession.
Fiscal policy works through government spending and revenues. For example, the government took a contractionary fiscal policy to lower inflation. The government will do this by raising taxes or reducing spending.
Now, say, the government raises taxes. The increase causes households and businesses to spend more dollars paying taxes. As a result, they have fewer dollars to spend on goods and services. As a result, demand tends to weaken as fewer dollars are spent on goods and services.
Weak demand slows the pace of rising prices for goods and services. This situation then encourages producers to reduce their production in response to weak demand and prices. As a result, it makes the economy’s output grow more slowly.
The central bank is responsible for carrying out monetary policy. And these policies affect the economy through their effect on the money supply, which eventually affects aggregate demand. Three common monetary policy tools are:
- Policy interest rate
- Reserve requirement ratio
- Open market operations
The central bank tries to lower the inflation rate by implementing a contractionary monetary policy (tight monetary policy). The central bank will do so using one or a combination of the following options:
- Raise policy interest rates
- Raising the reserve requirement ratio
- Open market operations by selling government securities
For example, the central bank chooses to raise interest rates. The increase will cause less money to circulate in the economy. As a result, liquidity tightens and pushes up interest rates in financial markets.
As interest rates rise, borrowing costs become more expensive. As a result, consumers and businesses reduce borrowing to finance consumption and investment because it is more expensive. This situation eventually causes aggregate demand to weaken and slows the rise in the price level.
What to read next
- Inflation Rate: How to Calculate, Types, Effects of Economic Policy
- Unemployment Rate: Formula, Types, Causes, and Effects
- Balance of Payment: Meaning, Formula, Component, Importance
- Economic Growth: Factors, Importance, Impacts, How to Measure It
- Income Distribution: How to Measure and Overcome Inequality
- What are the 5 macroeconomic objectives
- Possible Conflicts Between Macroeconomic Objectives