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Inflation is a constant force at play in the economy, affecting everything from your weekly grocery bill to the investment decisions of major corporations. It refers to the gradual increase in the general price level of goods and services over time. This means the same amount of money buys you less stuff as the years go by. Understanding inflation is crucial for anyone navigating the economic landscape, from students of economics to seasoned investors. This comprehensive guide will equip you with the knowledge to decode inflation’s impact on your wallet and the broader economy.
What is inflation?
Imagine you bought a cup of coffee for $1 five years ago. Today, that same cup might cost you $1.20. This gradual increase in prices across the board is what economists call inflation. It’s not just about coffee; inflation reflects a rise in the general price level of all goods and services in an economy over time.
Here’s the key distinction: If your favorite brand of sneakers suddenly becomes more expensive, that’s not necessarily inflation. However, if the prices of most goods and services you buy – from groceries to rent – tend to rise steadily, that indicates inflation at play.
Economists track inflation through price indexes, like the Consumer Price Index (CPI), which measures the average price changes of a basket of goods and services that consumers typically purchase. So, by understanding inflation, you gain insights into how much purchasing power your money holds over time.
Inflation can significantly impact your wallet and investment decisions. Here’s how:
- Erodes purchasing power: As prices rise due to inflation, the same amount of money buys you fewer goods and services. That morning cup of coffee you used to get for $1 now costs $1.20, meaning your $1 has less buying power.
- Borrowers vs. lenders: Inflation can be a double-edged sword. Borrowers benefit when inflation is present. If you borrow money today and pay it back later in a period of inflation, the money you repay has slightly less purchasing power than when you borrowed it. Conversely, lenders are negatively impacted by inflation as the real value of their loan repayments diminishes.
Understanding inflation empowers you to make informed financial decisions. Investors, for example, consider inflation when choosing investments to ensure their returns keep pace with rising prices. By grasping inflation’s influence, you can better manage your finances and navigate the economic landscape.
Indicators to measure 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 2022 is 132 and the consumer price index in 2023 is 140. Of the two figures, the inflation rate in 2023 is 6.1% = [(140/132) -1] x 100% = 6.1%.
Types of Inflation and Causes
Three types of inflation are widely known. They are:
- Cost-push inflation
- Demand-pull inflation
- Built-in inflation
Demand-pull 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.
In such situations, the economy usually 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
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, rising oil prices raise transportation costs in the economy and impact 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.
Built-in inflation
This type of inflation arises because of the influence of adaptive expectations and the price-wage spiral, which create future inflationary pressures. Usually, this type of inflation forms the core inflation component of the consumer price index.
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 labor costs usually cover a large portion of production costs, increased costs squeeze the 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.
Inflationary Terms
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 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. The cause is usually when the money supply in the economy starts to increase.
- Stagflation is a period of high inflation accompanied by high unemployment and slow economic growth. To remember it, we can divide “Stagflation” into “Stagnant growth” and “Inflation.”
- Galloping inflation refers to a condition when the inflation rate is high. Annually, the rate may be 50% higher 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 dollar today is more valuable than one dollar in the future. Or in other words, one dollar 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.
Moderate inflation: a sign of economic growth
Low price increases are normal when the economy grows. This is because a healthy economy experiences rising consumer demand for goods and services. Businesses respond by increasing production, which can sometimes lead to slight price hikes due to factors like resource scarcity or higher labor costs.
However, a moderate increase in inflation, typically around 2-3%, can actually be a sign of a thriving economy. In this sweet spot, inflation keeps pace with economic growth, and businesses are still incentivized to invest and expand. This overall economic expansion creates more jobs, boosts wages, and ultimately leads to a stronger economy for everyone.
High inflation: detrimental to the economy (investment, currency stability)
Conversely, high inflation is considered bad for the economy. If price increases go unchecked, it can wreak havoc on several fronts. Unpredictable and high inflation discourages investment. Businesses become hesitant to invest in long-term projects due to uncertainty about future costs and returns.
Similarly, consumers delay purchases on expensive items, waiting for prices to stabilize. This ultimately leads to a slowdown in economic activity. Furthermore, high inflation erodes the stability of a country’s currency.
As prices rise rapidly, the value of the currency itself decreases. This can lead to capital flight, where investors move their money to more stable economies. This loss of confidence in the currency can trigger a vicious cycle, further accelerating inflation and worsening economic conditions. Ultimately, high inflation can lead to social unrest and political instability.
Ideal scenario: low & stable inflation (inflation targeting)
Overall, low and stable inflation is preferred. This creates a predictable economic environment that fosters growth and investment. To achieve this, some countries adopt inflation targeting as their policy.
Central banks set a target range for the acceptable inflation rate, typically around 2-3%. When inflation falls outside this range, the central bank implements monetary policies to bring it back within the target zone. This approach helps maintain price stability while allowing for some growth-induced inflation.
When everyone believes that the central bank will effectively manage inflation within this range, spending and investment decisions can be made with greater confidence, promoting overall economic stability and growth.
Policies 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. This will reduce the demand for loans and weaken 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.
