What is inflation?
Inflation is the declining purchasing power of a given currency over time. It can reflect a quantitative estimate of the rate at which the decline in purchasing power occurs in the increase of an average price level of a basket of selected goods and a services in given economy over some time.
The increase in prices, also often expressed as a percentage, means that a currency unit effectively buys very less than it did in a very prior periods. It can contrast inflation with deflation, which occurs when the purchasing power of money increases and prices decline.
Understanding the concept of inflation
While measuring the price changes of individual products over time is easy, humans also need to extend beyond one or two such products. Individuals also need a big and diversified set of products and a host of services which helps in living a comfortable life.
They also include commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like healthcare, entertainment, and labour.
Normally, inflation aims for measuring the overall impact of the price, which changes for a very diversified set of a products and a services. This allows for a single value in representation of a increase in a particular price level of goods and a services in an existing economy over some time.
As a currency lost its value, prices will rise, and it will buy fewer goods and even services. This loss of purchasing power will impact the general cost of living for the common public, leading to a deceleration in economic growth.
The consensus among economists is that sustained inflation will occur when a nation’s money supply growth outpaces economic growth.
To combat this, appropriate monetary authority of the country, like the central bank, will take necessary steps for managing the supply of money and various credits for keeping the inflation within permissible limits and stabilizing the economy’s smooth function.
Theoretically, monetarism is a well-known theory that helps understand the relationship between inflation and the economic money supply.
E.g., following the Spanish conquest of the Aztec and Inca empires, a huge amount of gold and especially silver have flowed into the Spanish and other economies of European territories. Since the money supply has rapidly increased, the value of money fell, contributing to rapidly rising prices.
It can measure inflation in various ways. It depends upon the types of goods and services considered. It is the opposite of deflation, indicating a general decline in prices for goods and services when the inflation rate falls below 0%.
Causes of Inflation (Reason What is inflation?)
An you observe a increase in a money supply is root of inflation, though it can play this out through different economic mechanisms. There can be an increase in money supply by the monetary authorities either by printing and giving away more financial help to the individuals.
By legally devaluing the legally tender currencies, which is more commonly by loaning some new financial support into existence as reserve account credits through the banking system by the purchase of the government bonds from the banks on the secondary market.
In all such cases of an increase in money supply, the money loses its purchasing power. The working of how this drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.
Demand-pull inflation results in when an increase in a particular supply of money and a credit stimulates. The overall demand for services and goods in an economy to basically increase more fast than a economy’s of production capacity. It increases demand and leads to price rises.
How Does Inflation Work?
As there is higher availability of money for individuals, it will lead to positive consumer sentiment for higher spending; increasing demand pulls prices even higher. It will also create a gap in demand supply with higher demand and less flexible supply, which will result in higher prices.
Cost-push inflation increases the prices, which are working through the production process inputs.
In addition to the supply of money and credit are challan into a commodity or other asset markets, especially when a negative economic shock accompanies this into the supply of key commodities, which will increase costs for all kinds of intermediate goods.
These developments will lead to higher costs for the finished product or services and may even work their way into the rise of consumer prices.
For instance, when an expansion of money supply will creates a speculative type of boom in oil prices. The cost of a energy of all been sorts of uses can rise and to contribute to rising consumer prices. This reflected in various inflation measures.
Built-in inflation is also related to adaptive expectations, which people expect to continue the future inflation rate.
As there is an increase in prices of goods and services, workers and others expected that they will be continue to mainly rise in future at a very similar rate. The demand more of a costs or a wages to maintain one standard of living.
There is increased wages will result in a higher cost of goods and services and will continue this wage-price spiral as one factor that will induce the other and vice-versa.
All types of Price Indexes:
It mostly depends on the selected goods and services used; multiple goods baskets are calculated and tracked as price indexes. The consumer price index and a known wholesale price index is the most commonly used price indexes.
The Consumer Price Index when you look What is inflation?
The consumer price index is the measurement that helps in examining the weighted average in a prices of one basket of goods and a services. These are considered as primary consumer needs. They also include transportation, food, and various medical care.
Consumer Price Index can be calculated by taking changes in price for each one of item in the preset defined basket of a goods and a averaging. It is based on their relative weight in the whole basket. The prices are considered the retail prices of each item, as it is available for sale by the individual citizens.
Changes in the consumer price index are used to mainly assess price changes which are associated with the cost of living and making it one of the most very frequently used type of statistics for mainly identifying a periods of an inflation or a deflation.
In the country United States, the Bureau of Labor Statistics reports the Consumer Price Index every month and has been calculated it as far a back in year 1913.
The Wholesale Price Index
The Wholesale Price Index is another popular measure of inflation, which measures and tracks the prices of goods in the stages before the level of retail.
While Wholesale Price Index items vary from one country to another, they mostly include items of the producer or wholesale level.
E.g., it includes cotton prices for raw cotton, cotton yarn, cotton grey goods, and cotton clothing.
Although several countries and organizations use WPI, many other countries, including the U.S., use one type of a similar variant which is called the producer price index (PPI).
The Producer Price Index
The producer price index is mainly a indexes of family that is measuring by an average change in a selling prices is that is received by a domestic and local producers of an intermediate type of goods and services over time.
The many PPI measures will have price changes from seller’s perspective and differs from the CPI, which measures price changes from the buyer’s perspective.
In all such variants, the rise in the price of one component (say oil) may cancel out the price, which is declining in another way (say wheat) to a certain extent. Overall, each index will mainly a weighted average that are price change for a been given type of constituents which may have been apply for the overall , economy, sector or commodity level.
Formula for finding and Measuring Inflation:
The variants mentioned above can calculate inflation value between two particular months (or years). While many ready-made inflation calculators are already available on various financial portals and the websites, it is been always better to be have aware of underlying type of methodology to ensure an accuracy with a very clear understanding of calculations.
Pros and Cons:
Inflation can be construed as a good or a bad thing. It depends upon which side one takes and how rapidly the change occurs.
For example, individuals with a tangible assets priced in currency, like a property or a stocked commodities. This may likely see of some inflation as that are raises with the price of their assets, for which they can sell at a special higher rate.
However, the buyers of such assets might not be satisfied with inflation, as they will require to shell out more money. Inflation-indexed bonds are also considered as another popular option for investors to earn profit from inflation.
On the other hand, holding assets is denominated in a currency like cash or bonds. It may also not like inflation, as it will erode the real value of their holdings.
But investors are looking to protect their portfolios from inflation and should be considered inflation-hedged asset classes like gold, commodities, and real estate investment trusts.
Inflation also promotes speculation, both by risky business projects and by individuals in stocks of the companies, as they can expect better returns than inflation.
It can also promote an optimum level of inflation for encouraging spending to a certain extent instead of saving. If the purchasing power of money decreases over time, then there may be a greater incentive for spending instead of saving and spending it later.
It may also increase spending, which may also boost economic activities in a country. A balanced approach is also thought to keep the inflation value in an optimum and desirable range.
It can be imposed High and variable rates of inflation at high costs on an economy. Businesses, workers, and consumers must account for the effects of generally rising prices in their buying, selling, and planning decisions.
It introduces an additional source of uncertainty into the economy because they may guess wrong about the future inflation rate.
Time and resources are included in researching, estimating, and adjusting economic behavior are expected to rise to the general level of prices. Rather than real economic fundamentals, it inevitably represents a cost to the economy as a whole.
Even a low, stable, and easily predictable inflation rate, which some consider otherwise optimal, may lead to serious economic problems because of how, where, and when the new money enters the economy.
Whenever new money and credit enter the economy, it is always in the hands of specific individuals or business firms. The price level adjustment process to the new money supply helps in proceeding as they then spend the new money. It is also circulated from hand to hand and account to account throughout the economy.
Along the way, it also drives up some prices first and later, which will drive up other prices. These sequential changes in purchasing power and prices are known as the Cantillon effect.
It means that inflation will increase the general price level over time and distort relative of prices, rates of return, and wages along the way.
In general, economists understand that the distortions of relative prices away from their economic equilibrium are not healthy for the economy. Even Austrian economists believe that this process is a major driver of recession cycles in the economy.
Controlling the Inflation:
A country’s financial regulator supports the important responsibility for keeping inflation in check. It is done by implementing the measures through monetary policy, which is also referred to as a central bank or other committees determined as the size and rate of growing money supply.
In the United States, the Fed’s monetary policy goals include moderate long-term interest rates, price stability, and maximum employment.
Each of these goals is intended for promoting a stable financial environment. The Federal Reserve communicates long-term inflation goals to keep a steady long-term inflation rate, which is beneficial to the economy.
Price stability or a relatively constant inflation level will allow businesses to plan the future since they will know what to expect.
The Fed usually believes that this will promote maximum employment, determined by non-monetary factors that fluctuate over time and are subject to changes.
Because of this reason, the Fed doesn’t set a specific goal for maximum employment, and employers’ assessments largely determine it. Maximum employment does not always mean zero unemployment, as at any given time, there can be a certain level of volatility as people are vacant and starting new jobs.
Monetary authorities are also taking exceptional measures in intense conditions of the economy.
E.g., following the 2008 financial crisis, the United States Fed has kept the interest rates nearly zero and pursued a bond for buying the program, known as quantitative easing.
Some critics of the program are allegedly causing a spike in inflation in the United States dollar, but inflation was peaked in 2007 and started to decline steadily over the next eight years. There are also many complex reasons why QE did not lead to inflation or hyperinflation.
However, the easiest explanation is that the recession was itself a very prominent deflationary environment, and quantitative easily supporting its effects.
Consequently, the United States policymakers have attempted to keep inflation steady at around 2% per year.
The European Central Bank has pursued an aggressive type of quantitative of easing to counter deflation in Eurozone. Some places have experienced interest negative rates due to fears that deflation could take hold in the Eurozone and lead to economic stagnation.8
Moreover, those countries that are experiencing higher rates of growth can also absorb higher rates of inflation. India is targeting around 4%, while Brazil is aiming for 4.25%.
Hedging Against for Inflation. To know details on What is inflation?
It is considered that the Stocks are the best hedge against inflation, as their rise in stock prices is inclusive of inflation.
According to the additions to money supply in a virtually all type of modern economies occur as bank credit and a injections through the known financial system. Much of immediate that effect on a prices happens in financial assets priced in the currency, such as stocks.
Additionally, some special financial instruments exist which one can use to safeguard investments against inflation.
They include Treasury Inflation-Protected Securities, low-risk Treasury security, indexed for inflation where the principal amount is invested in increasing by the percentage of inflation.
One can also opt for a Treasury Inflation-Protected Securities mutual fund or TIPS-based exchange-traded fund (ETFs).
To get access to stocks, exchange-traded funds, and other funds that can help for avoiding any dangers in inflation. You will be very likely that a brokerage account. This will help while choosing a stockbroker or agent can be a hard process due to there are varieties among them.
Gold is also considered as a hedge against inflation, although this does not always appear to be the case for looking backwards.
Some Extreme Examples of Inflation:
As all the world currencies are fiat money, the money supply could increase rapidly for political reasons, resulting in rapid price increases.
The most well-known example is the hyperinflation that struck the German Weimar Republic in the early 1920s.
In World War I, the nations that had been victorious have been demanded reparations from Germany, which cannot be paid in German paper currency, as this can be suspect value due to the government’s borrowing. Germany also attempted to print paper notes, buy out the foreign currency with them, and later use that to pay their debts.
This policy also led to the rapid devaluation of the German mark and hyperinflation, which was accompanied by development.
Eventually, German consumers also responded to the cycle by spending their money as fast as possible, understanding that it would be worthless and less the longer they would have waited.
It would flood more and more money in the economy, and its value plummeted to the point where the population would paper their walls with practically worthless bills. Similar situations have been faced in Peru in 1990 and also in 2007-08 in Zimbabwe.
Frequently Asked Questions:
What are the reasons for causing the inflation?
There are three main reasons for causing inflation: demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull inflation is referred to when there are basically not enough products or a services that are being produced to mainly keep up with a demand, that are causing the prices to increase.
On the other hand, cost-push inflation is faced when producing products and services increases, which forces businesses to raise their prices.
Lastly, when we built-in inflation it sometimes to be referred to as a “wage-price spiral”. It occurs when a workers demand higher wages to keep up with rising living costs. It, in turn, causes businesses to raise their prices to offset their rise in wage costs which will lead to a self-reinforcing loop of wages and price increase.
Is inflation considered as good or bad?
Too much inflation is normally considered bad for an economy, while very little inflation is also considered harmful. Many economists also advocate for a middle-ground of 2% per year low to moderate inflation.
Generally speaking of the economy, higher inflation also harms savers because it usually erodes the purchasing power of the money that they have saved. However, it can benefit the borrowers because the inflation-adjusted value of their outstanding debts shrinks over time.
What are the various effects of inflation?
Inflation can be effective for the economy in several ways. E.g., suppose inflation is causing a nation’s currency to decline. In that case, this can be beneficial for the exporters by making their goods more affordable when it is priced in the currency of foreign nations.
When any one scrutinize on what is inflation it happen. can be harmful to the importers by making foreign-made goods more expensive. Higher inflation can also help encourage spending, as consumers will aim to purchase goods quickly before their prices rise further. On the other hand, Savers could ever see the main real value in savings erode, limiting their type of ability to pay or do invest in future.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on email@example.com or firstname.lastname@example.org.