What Is Inflation?

Inflation is a rise in prices, which can be translated as the decline

of purchasing power over time. The rate at which purchasing power drops
can be reflected in the average price increase of a basket of selected
goods and services over some period of time. The rise in prices, which is
often expressed as a percentage, means that a unit of currency effectively
buys less than it did in prior periods. Inflation can be contrasted
with deflation, which occurs when prices decline and purchasing power
increases.

 Inflation is the rate at which prices for goods and services rise.
 Inflation is sometimes classified into three types: demand-pull inflation,
cost-push inflation, and built-in inflation.
 The most commonly used inflation indexes are the Consumer Price
Index and the Wholesale Price Index.
 Inflation can be viewed positively or negatively depending on the
individual viewpoint and rate of change.
 Those with tangible assets, like property or stocked commodities, may
like to see some inflation as that raises the value of their assets.

Understanding Inflation
While it is easy to measure the price changes of individual products over
time, human needs extend beyond just one or two products. Individuals need
a big and diversified set of products as well as a host of services for living a
comfortable life. They include commodities like food grains, metal, fuel,
utilities like electricity and transportation, and services like healthcare,
entertainment, and labor.

Inflation aims to measure the overall impact of price changes for a diversified
set of products and services. It allows for a single value representation of the
increase in the price level of goods and services in an economy over a period
of time.

Prices rise, which means that one unit of money buys fewer goods and
services. This loss of purchasing power impacts the cost of living for the
common public which ultimately leads to a deceleration in economic growth.
The consensus view among economists is that sustained inflation occurs
when a nation's money supply growth outpaces economic growth.
3.7%
The change in the Consumer Price Index For All Urban Consumers (CPI-
U) over the 12-month period ending Aug. 2023. Prices rose 0.6% on
seasonal
adjusted To combat this, the monetary authority (in most cases, the central
bank) takes the necessary steps to manage the money supply and credit to
keep inflation within permissible limits and keep the economy running
smoothly.
Theoretically, monetarism is a popular theory that explains the relationship
between inflation and the money supply of an economy. For example,
following the Spanish conquest of the Aztec and Inca empires, massive
amounts of gold and especially silver flowed into the Spanish and other
European economies. Since the money supply rapidly increased, the value of
money fell, contributing to rapidly rising prices.3

Inflation is measured in a variety of ways depending on the types of goods

and services. It is the opposite of deflation, which indicates a general decline
in prices when the inflation rate falls below 0%. Keep in mind that deflation
shouldn't be confused with disinflation, which is a related term referring to a
slowing down in the (positive) rate of inflation.

Causes of Inflation
An increase in the supply of money is the root of inflation, though this can
play out through different mechanisms in the economy. A country's money
supply can be increased by the monetary authorities by:

 Printing and giving away more money to citizens

 Legally devaluing (reducing the value of) the legal tender currency
 Loaning new money into existence as reserve account credits through
the banking system by purchasing government bonds from banks on
the secondary market (the most common method)

In all of these cases, the money ends up losing its purchasing power. The
mechanisms of how this drives inflation can be classified into three types:
demand-pull inflation, cost-push inflation, and built-in inflation.

Built-in Inflation

Built-in inflation is related to adaptive expectations or the idea that people

expect current inflation rates to continue in the future. As the price of goods
and services rises, people may expect a continuous rise in the future at a
similar rate. As such, workers may demand more costs or wages to maintain
their standard of living. Their increased wages result in a higher cost of goods
and services, and this wage-price spiral continues as one factor induces the
other and vice-versa.

#1 – Demand Pull Inflation

It occurs when the demand exceeds supply. Thus, forcing the firms to
increase the prices. For instance, the Lawson boom of the late 1980s.
At that moment, the United Kingdom saw a huge rise in the prices of
houses. Also, household consumption increased massively. Therefore,
as a result of increasing prices, the demand surpassed supply.

#2 – Creeping Inflation
In the initial stage, the inflation rate is around 2%, 3%, or 5%. At this
point, the prices rise at a very minimal rate gradually. However,
ignoring them can cause prices to rise.

#3 – Cost-Pull Inflation
This situation appears when the cost of production forces firms to
increase their prices. For example, the factors of production like
labor, raw material, and technology are getting expensive.

#4 – Walking Inflation
The hike is said to be walking when the rate rises by 3% to 10% yearly.
In September 2022, Sweden’s central bank announced an inflation
report of 9%, probably the highest since 1990. Later, the western
countries had inflation news of 7-8%.
#5 – Galloping Inflation
Galloping inflation occurs when the rate is between 20-1000%. In such
situations, there is too much instability within the economy. As a
result, the governing bodies fail to bring situations within control. For
example, in the 1990s, Russia faced a galloping situation where the
prices of food and goods increased severely. In 1993, the rate in Russia
was 839.21 %.

#6 – Hyperinflation
Hyperinflation occurs when the rate is above 1000%. At this stage,
the value of money depreciates faster

Types of Price Indexes

Depending upon the selected set of goods and services used, multiple types
of baskets of goods are calculated and tracked as price indexes. The most
commonly used price indexes are the Consumer Price Index (CPI) and
the Wholesale Price Index (WPI).

The Consumer Price Index (CPI)

The CPI is a measure that examines the weighted average of prices of a

basket of goods and services that are of primary consumer needs. They
include transportation, food, and medical care.

CPI is calculated by taking price changes for each item in the predetermined
basket of goods and averaging them based on their relative weight in the
whole basket. The prices in consideration are the retail prices of each item,
as available for purchase by the individual citizens.

Changes in the CPI are used to assess price changes associated with
the cost of living, making it one of the most frequently used statistics for
identifying periods of inflation or deflation. In the U.S., the Bureau of Labor
Statistics (BLS) reports the CPI on a monthly basis and has calculated it as
far back as 1913.4

The CPI-U, which was introduced in 1978, represents the buying habits of
approximately 88% of the non-institutional population of the United States.56

The Wholesale Price Index (WPI)

The WPI is another popular measure of inflation. It measures and tracks the
changes in the price of goods in the stages before the retail level.

While WPI items vary from one country to another, they mostly include items
at the producer or wholesale level. For example, it includes cotton prices for
raw cotton, cotton yarn, cotton gray goods, and cotton clothing.7

Although many countries and organizations use WPI, many other countries,
including the U.S., use a similar variant called the producer price index
(PPI).8

The Producer Price Index (PPI)

The PPI is a family of indexes that measures the average change in selling
prices received by domestic producers of intermediate goods and services
over time. The PPI measures price changes from the perspective of the seller
and differs from the CPI which measures price changes from the perspective
of the buyer.9

In all variants, it is possible that the rise in the price of one component (say
oil) cancels out the price decline in another (say wheat) to a certain extent.
Overall, each index represents the average weighted price change for the
given constituents which may apply at the overall economy, sector, or
commodity level.

The Formula for Measuring Inflation

The above-mentioned variants of price indexes can be used to calculate the
value of inflation between two particular months (or years). While a lot of
ready-made inflation calculators are already available on various financial
portals and websites, it is always better to be aware of the underlying
methodology to ensure accuracy with a clear understanding of the
calculations. Mathematically,
Percent Inflation Rate = (Final CPI Index Value ÷ Initial CPI Value) x 100
Say you wish to know how the purchasing power of $10,000 changed
between September 1975 and September 2018. One can find price index
data on various portals in a tabular form. From that table, pick up the
corresponding CPI figures for the given two months. For September 1975, it
was 54.6 (initial CPI value) and for September 2018, it was 252.439 (final CPI
value).1011

Plugging in the formula yields:

Percent Inflation Rate = (252.439 ÷ 54.6) x 100 = (4.6234) x 100 = 462.34%

Since you wish to know how much $10,000 from September 1975 would
worth be in September 2018, multiply the inflation rate by the amount to get
the changed dollar value:

Change in Dollar Value = 4.6234 x $10,000 = $46,234.25

This means that $10,000 in September 1975 will be worth $46,234.25.
Essentially, if you purchased a basket of goods and services (as included in
the CPI definition) worth $10,000 in 1975, the same basket would cost you
$46,234.25 in September 2018.

Advantages and Disadvantages of Inflation

Inflation can be construed as either a good or a bad thing, depending upon
which side one takes, and how rapidly the change occurs.

Advantages

Individuals with tangible assets (like property or stocked commodities) priced

in their home currency may like to see some inflation as that raises the price
of their assets, which they can sell at a higher rate.

Inflation often leads to speculation by businesses in risky projects and by

individuals who invest in company stocks because they expect better returns
than inflation.

An optimum level of inflation is often promoted to encourage spending to a

certain extent instead of saving. If the purchasing power of money falls over
time, then there may be a greater incentive to spend now instead of saving
and spending later. It may increase spending, which may boost economic
activities in a country. A balanced approach is thought to keep the inflation
value in an optimum and desirable range.

Disadvantages

Buyers of such assets may not be happy with inflation, as they will be
required to shell out more money. People who hold assets valued in their
home currency, such as cash or bonds, may not like inflation, as it erodes the
real value of their holdings. As such, investors looking to protect their
portfolios from inflation should consider inflation-hedged asset classes, such
as gold, commodities, and real estate investment trusts (REITs). Inflation-
indexed bonds are another popular option for investors to profit from inflation.

High and variable rates of inflation can impose major costs on an economy.
Businesses, workers, and consumers must all account for the effects of
generally rising prices in their buying, selling, and planning decisions.

This introduces an additional source of uncertainty into the economy,

because they may guess wrong about the rate of future inflation. Time and
resources expended on researching, estimating, and adjusting economic
behavior are expected to rise to the general level of prices. That's opposed to
real economic fundamentals, which inevitably represent a cost to the
economy as a whole.

Even a low, stable, and easily predictable rate of inflation, which some
consider otherwise optimal, may lead to serious problems in the economy.
That's because of how, where, and when the new money enters the
economy.

Whenever new money and credit enter the economy, it is always into the
hands of specific individuals or business firms. The process of price level
adjustments to the new money supply proceeds as they then spend the new
money and it circulates from hand to hand and account to account through
the economy.

Inflation does drive up some prices first and drives up other prices later. This
sequential change in purchasing power and prices (known as the Cantillon
effect) means that the process of inflation not only increases the general price
level over time. But it also distorts relative prices, wages, and rates of return
along the way.12
Economists, in general, understand that distortions of relative prices away
from their economic equilibrium are not good for the economy, and Austrian
economists even believe this process to be a major driver of cycles of
recession in the economy.13

Pros
 Leads to higher resale value of assets
 Optimum levels of inflation encourage spending

Cons
 Buyers have to pay more for products and services
 Impose higher prices on the economy
 Drives some prices up first and others later

Extreme Examples of Inflation

Since all world currencies are fiat money, the money supply could increase
rapidly for political reasons, resulting in rapid price level increases. The most
famous example is the hyperinflation that struck the German Weimar
Republic in the early 1920s.

The nations that were victorious in World War I demanded reparations from
Germany, which could not be paid in German paper currency, as this was of
suspect value due to government borrowing. Germany attempted to print
paper notes, buy foreign currency with them, and use that to pay their debts.

This policy led to the rapid devaluation of the German mark along with the
hyperinflation that accompanied the development. German consumers
responded to the cycle by trying to spend their money as fast as possible,
understanding that it would be worth less and less the longer they waited.
More and more money flooded the economy, and its value plummeted to the
point where people would paper their walls with practically worthless bills.
Similar situations occurred in Peru in 1990 and in Zimbabwe between 2007
and 2008.252627

What Causes Inflation?

There are three main causes of inflation: demand-pull inflation, cost-push
inflation, and built-in inflation.
  Demand-pull inflation refers to situations where there are not enough
products or services being produced to keep up with demand, causing
their prices to increase.
 Cost-push inflation, on the other hand, occurs when the cost of
producing products and services rises, forcing businesses to raise their
prices.
 Built-in inflation (which is sometimes referred to as a wage-price spiral)
occurs when workers demand higher wages to keep up with rising living
costs. This in turn causes businesses to raise their prices in order to
offset their rising wage costs, leading to a self-reinforcing loop of wage
and price increases.

Is Inflation Good or Bad?

Too much inflation is generally considered bad for an economy, while too little
inflation is also considered harmful. Many economists advocate for a middle
ground of low to moderate inflation, of around 2% per year.

Generally speaking, higher inflation harms savers because it erodes the

purchasing power of the money they have saved; however, it can benefit
borrowers because the inflation-adjusted value of their outstanding debts
shrinks over time.

What Are the Effects of Inflation?

Inflation can affect the economy in several ways. For example, if inflation
causes a nation’s currency to decline, this can benefit exporters by making
their goods more affordable when priced in the currency of foreign nations.

On the other hand, this could harm importers by making foreign-made goods
more expensive. Higher inflation can also encourage spending, as
consumers will aim to purchase goods quickly before their prices rise further.
Savers, on the other hand, could see the real value of their savings erode,
limiting their ability to spend or invest in the future.

Why Is Inflation So High Right Now?

In 2022, inflation rates in the U.S. and around the world rose to their highest
levels since the early 1980s. While there is no single reason for this rapid rise
in global prices, a series of events worked together to boost inflation to such
high levels.2829
The COVID-19 pandemic in early 2020 led to lockdowns and other restrictive
measures that greatly disrupted global supply chains, from factory closures to
bottlenecks at maritime ports. At the same time, governments issued stimulus
checks and increased unemployment benefits to help blunt the financial
impact of these measures on individuals and small businesses. When
COVID-19 vaccines became widespread and the economy rapidly bounced
back, demand (fueled in part by stimulus money and low interest rates)
quickly outpaced supply, which still struggled to get back to pre-COVID
levels.

Russia's unprovoked invasion of Ukraine in early 2022 led to a series of

economic sanctions and trade restrictions on Russia, limiting the world's
supply of oil and gas since Russia is a large producer of fossil fuels. At the
same time, food prices rose as Ukraine's large grain harvests could not be
exported. As fuel and food prices rose, it led to similar increases down the
value chains.

The Bottom Line

Inflation is a rise in prices, which results in the decline of purchasing power
over time. Inflation is natural and the U.S. government targets an annual
inflation rate of 2%; however, inflation can be dangerous when it increases
too much, too fast. Inflation makes items more expensive, especially if wages
do not rise by the same levels of inflation. Additionally, inflation erodes the
value of some assets, especially cash. Governments and central banks seek
to control inflation through monetary policy.