Inflation is an increase in the general level of prices of goods and services in the economy over time. If the price of one item or several items rises, it is not inflation. If inflation exists, the prices of all goods and services increase, as indicated by changes in the price index.
Measure and calculate inflation
Economists observe inflation through several price indexes. This index represents the price development of a basket of goods and services purchased by consumers and producers.
Price index varies between countries, both related to the type of goods and services and the weighting in the calculation. In general, there are three leading indices to measure inflation, namely:
- Consumer price index (CPI)
- Producer price index (PPI)
- GDP deflator
The consumer price index tracks changes in the prices of goods and services purchased by consumers, while the producer price index is for products and services purchased by producers. Meanwhile, economists calculate the GDP deflator by dividing nominal GDP into real GDP. Of the three, economists, policymakers, and analysts more often cite the consumer price index as an indicator of inflation.
Now let’s use the consumer price index to calculate inflation. We calculate the inflation rate from changes in the current consumer price index to the previous period, usually year on year.
Inflation rate = [(CPIt / CPIt-1) -1] x 100%
For example if the consumer price index in 2017 is 132 and the consumer price index in 2018 is 140. Of the two figures, the inflation rate in 2018 is 6.1% = [(140/132) -1] x 100% = 6.1% . The following are inflation trends in Indonesia and the United States since 1999, and the forecast is up to 2024.
Types of inflation and their causes
Three types of inflation are widely known. They are:
- Cost-push inflation
- Demand-pull inflation
- Built-in inflation
This type of inflation occurs because of high aggregate demand in the economy. It often occurs when the economy expands, which encourages households to increase spending on goods and services.
When aggregate demand is higher than aggregate supply, there is a shortage in the economy. This situation will increase the pressure on the prices of goods and services. This pressure usually occurs when the economy is in a boom phase.
Inflation occurs when real GDP is higher than potential GDP (positive output gap). In this situation, real output is higher than the production capacity in the economy. As a result, price pressures increase.
Usually, in such situations, the economy also experiences a trade deficit. A positive output gap indicates that domestic production capacity is insufficient to meet demand. Therefore, inevitably, the economy must supply it from abroad (higher imports).
Cost-push inflation occurs because there is a substantial increase in production costs. Also, the cause can occur because there are supply-side shocks such as natural disasters, which can shrink supply suddenly.
An example of an increase in production costs that causes a surge in inflation is the increase in oil prices. As we know, oil is an essential commodity now. Its use covers various sectors, not only as a transportation fuel. In particular, for fuel, rising oil prices cause transportation costs in the economy to be higher and have an impact on the production costs of many companies.
Increased production costs force businesses to raise prices to maintain their profitability margins. When many producers raise their selling prices, inflationary pressures will strengthen.
This situation has occurred in Indonesia during 2014-2015. In these two years, inflation jumped to above 8% from below 4% in 2013. The reason is high oil prices, reaching more than USD100 per barrel.
This type of inflation arises because of the influence of adaptive expectations and the price-wage spiral, which creates future inflationary pressures. Usually, of the consumer price index components, this type of inflation forms the core inflation component.
During inflation, workers realize that their real wages are falling because the prices of goods and services rise more than their nominal wages. To maintain the cost of living, they then demand higher nominal wages.
Because, usually, labor costs cover a large portion of production costs, increased cost squeezes profit margin. Thus, to maintain the margin, businesses pass-through the nominal wage to the selling price. Thus, a higher nominal wage now induces a higher price level.
The increase in selling prices, in turn, encourages workers to renegotiate even higher wages. This process continues and creates a spiral of wage-price effects in the economy.
In discussing inflation, there are several terms that you need to know. They are:
- Disinflation. It refers to a slower rate of inflation, for example, from 5% to 3%. Please note that the percentage is still higher than zero; only the value decreases from the previous period.
- Deflation. It happens when the price level drops continuously. Therefore, the inflation rate is negative (below zero). It is generally associated with a deep recession.
- Hyperinflation. It is a phenomenon of very high price increases. It can be caused by supply shocks, war, or the transition of economic regimes. The inflation rate can reach up to 500% in a month. Zimbabwe and Venezuela are the two countries that have experienced it recently.
- Reflation. This term describes the first phase of inflation after a period of deflation. Usually, the cause is when the money supply in the economy starts to increase.
- Stagflation. It is a period of high inflation accompanied by high unemployment and slow economic growth. To remember it, we can break down the word “Stagflation” into “Stagnant growth” and “Inflation.”
- Galloping inflation. It refers to a condition when the inflation rate is high. Annually, the rate may be in the range of 50% more, but lower than hyperinflation.
- Creeping inflation. This type of inflation is still in the single digits but is higher than the historical average.
Why inflation is important in the economy
An increase in the general price level erodes the purchasing power of domestic currencies. Therefore, when there is inflation, one rupiah today is more valuable than one rupiah in the future. Or in other words, one rupiah now can buy more goods than in the future.
Inflation benefits borrowers at the expense of lenders. When a borrower pays the principal, the purchasing power of money is lower than when borrowed. So, to compensate for this risk, the lender adds a percentage of interest as a premium.
Low price increases are frequent when the economy grows. Therefore, a moderate increase in inflation can indicate the economy is growing. In this situation, inflation is not a problem.
Conversely, high inflation is considered bad for the economy. If price increases go unchecked, it can destroy a country’s monetary system, cause political risks, and hinder investment in those countries. People lose confidence in currencies and can worsen living standards.
Overall, low and stable inflation is preferred. Therefore, some countries adopt inflation targeting as their policy. They determine the range of acceptable inflation rates. When everyone believes that the central bank will move to control inflation within that range, spending and investment decisions will be made wisely.
Policy to influence inflation
By looking at the rate of inflation, we can assess the state of the economy and predict changes in monetary policy, which have a significant impact on our daily lives. If high price increases are accompanied by high economic growth, the economy is overheating. It urges the monetary authorities to take steps to cool it down, for example, by raising policy rates.
Higher policy rates will encourage commercial banks to increase their loan rates, making the cost of funds more expensive than before. It reduces the demand for loans and weakens spending on goods and services, whether by households or businesses. Lower spending reduces aggregate demand, thereby limiting inflation and moderating economic growth.
Conversely, slow economic growth and too-low inflation usually push monetary authorities to adopt expansionary policies, for example, by cutting policy rates. Lower interest rates increase aggregate demand and economic output, which leads to an increase in inflation.