What Is Inflation and How Does It Affect You?
Inflation is the gradual loss of a currency’s buying value over time. The increase in the average price level of a basket of selected goods and services in an economy over time can be used to calculate a quantitative estimate of the rate at which buying power declines. A rise in the general level of prices, which is frequently stated as a percentage, signifies that a unit of currency now buys less than it did previously.
Inflation is distinguished from deflation, which happens when money’s purchasing power rises but prices fall.
Important Points to Remember
- Inflation is defined as the rate at which a currency’s value falls and, as a result, the overall level of prices for goods and services rises.
- There are three forms of inflation that are commonly used to classify it: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation are the three types of inflation.
- The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most widely used inflation indices (WPI).
- Depending on one’s perspective and rate of change, inflation can be perceived favourably or negatively.
Those possessing tangible assets, such as real estate or stockpiled goods, may benefit from inflation because it increases the value of their holdings.
While it is simple to track the price fluctuations of particular things over time, human demands are much more complex. Individuals require a large and diverse range of items as well as a variety of services in order to live comfortably. Commodities such as food grains, metal, and fuel, utilities such as power and transportation, and services such as healthcare, entertainment, and labor are among them.
Inflation is a term used to describe the overall impact of price changes across a wide range of goods and services, and it allows for a single value representation of the rise in the price level of goods and services in an economy over time.
At its June 2021 meeting, the US Federal Reserve made no changes to its rate policy and expressed no concerns about growing inflation. According to the US Bureau of Labor Statistics (BLS), the Consumer Price Index For All Urban Consumers (CPI-U) increased by 6.2 percent in the 12-month period ending October 2021, surpassing the previous high of 5.4 percent in the 12-month period ending August 2008.
Prices rise as a currency loses value, and it can buy fewer products and services. This loss of purchasing power has an influence on the general cost of living for the general people, resulting in a slowdown in economic growth. Economists agree that sustained inflation happens when a country’s money supply grows faster than its economic growth.
To combat this, the competent monetary authority in a country, such as the central bank, takes the required steps to manage the supply of money and credit in order to maintain inflation within acceptable bounds and the economy functioning smoothly.
Monetarism is a common hypothesis that explains the relationship between inflation and an economy’s money supply. Following the conquest of the Aztec and Inca empires by the Spanish, vast sums of gold and metal, particularly silver, poured into the Spanish and other European economies. The value of money has fallen as the money supply has expanded rapidly, contributing to swiftly rising prices.
Inflation is quantified in a variety of ways based on the sorts of goods and services studied, and it is the polar opposite of deflation, which occurs when the inflation rate falls below 0% and shows a general decrease in prices for goods and services.
Inflation is caused by a rise in the quantity of money, which can occur through a variety of causes in the economy. The monetary authorities can increase the money supply by printing and giving out more money to individuals, legally devaluing (decreasing the value of) the legal tender currency, or more commonly (and most commonly) by lending new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market.
When the money supply is increased in this way, the money loses its purchasing power. There are three sorts of mechanisms that generate inflation: demand-pull inflation, cost-push inflation, and built-in inflation.
The Push-Pull Effect
Demand-pull Inflation happens when the supply of money and credit expands faster than the economy’s production capacity, causing overall demand for goods and services to rise faster than the economy’s production capacity. As a result, demand grows and prices rise. investingclue, Melissa Ling Copyright, 2019.
Positive consumer sentiment leads to increased spending as more money becomes available to individuals, and this increased demand drives prices upward. It causes a demand-supply gap, resulting in higher prices due to higher demand and less flexible supply.
The Cost-Pushing Effect
Cost-push inflation occurs when prices rise as a result of increased input costs in the manufacturing process. Costs for all sorts of intermediate goods rise when increases in the supply of money and credit are funneled into commodity or other asset markets, especially when this is accompanied by a negative economic shock to the supply of important commodities.
These developments result in higher completed product or service costs, which in turn contribute to increased consumer pricing. For example, when the money supply expands and a speculative boom in oil prices occurs, the cost of energy for various purposes can rise, contributing to rising consumer prices, as measured by various inflation metrics.
Inflation is pre-installed.
Adaptive expectations, or the assumption that individuals expect current inflation rates to continue in the future, is linked to built-in inflation. Workers and others come to expect that the price of goods and services will continue to climb at a similar rate in the future, and they demand higher costs or wages to maintain their level of life. Their greater incomes lead to higher prices for products and services, and this wage-price spiral continues as one component causes the other.
Price Indices: What Are They and How Do They Work?
Multiple sorts of baskets of commodities are calculated and tracked as price indexes based on the selected set of goods and services. The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most widely used price indexes (WPI).
The Consumer Price Index is a measure of how much something costs.
The Consumer Price Index (CPI) is a weighted average of prices for a basket of goods and services that are essential to consumers. Transportation, food, and medical care are among them. The CPI is derived by averaging price increases for each item in a predetermined basket of products based on their relative weight in the basket. The prices taken into account are the retail pricing of each item as they are accessible for purchase by individuals.
The CPI is one of the most often used indicators for detecting periods of inflation or deflation since it is used to measure price changes linked with the cost of living. The Bureau of Labor Statistics in the United States calculates the CPI on a monthly basis and has done so since 1913.
Revisions to the CPI
Six times the Consumer Price Index has been changed. The Consumer Price Index for All Urban Consumers (CPI-U), which was first published in 1978, represents the purchasing habits of roughly 80% of the non-institutional population in the United States.
The Wholesale Price Index (WPI)
Another prominent indicator of inflation is the WPI, which tracks and assesses changes in the price of items before they reach the retail level. While WPI commodities differ from country to country, they typically consist of producer or wholesale items. Cotton costs for raw cotton, cotton yarn, cotton gray items, and cotton garments, for example, are all included.
Although WPI is used by many countries and organizations, the producer price index is used by many others, including the United States (PPI).
The Producer Price Index (PPI) is a measure of how much
The producer price index is a collection of indicators that track the average change in selling prices for intermediate goods and services received by domestic producers across time. The PPI monitors price changes from the seller’s perspective, as opposed to the CPI, which measures price changes from the buyer’s perspective.
In any of these scenarios, it’s feasible that a price increase for one component (say, oil) partially offsets a price decrease for another (say, wheat). Overall, each index indicates the average weighted price change for the provided elements, which can be applied to the entire economy, a specific industry, or a specific product.
The Inflation Calculation Formula
The price indexes listed above can be used to calculate the difference in inflation between two months (or years). While there are numerous ready-made inflation calculators available on various financial portals and websites, it is always preferable to grasp the underlying approach in order to assure accuracy and a clear understanding of the estimates. Mathematically,
(Final CPI Index Value/Initial CPI Value)*100 = percent inflation rate
Assume you want to see how $10,000’s purchasing power changed from September 1975 to September 2018. Price index data can be found in a tabular format on many portals. Select the relevant CPI values for the provided two months from that table. It was 54.6 (first CPI figure) in September 1975 and 252.439 in September 2018. (Final CPI value). When you plug in the formula, you get:
(252.439/54.6)*100 = (4.6234)*100 = 462.34 percent inflation rate
To find out how much $10,000 in September 1975 would be worth in September 2018, multiply the percent inflation rate by the amount:
4.6234 * $10,000 = $46,234.25 change in monetary value
This suggests that $10,000 will be worth $46,234.25 in September 1975. In other words, if you bought a $10,000 basket of goods and services (as defined by the CPI) in 1975, the same basket would cost you $46,234.25 in September 2018.
The Benefits and Drawbacks of Inflation
Depending on which side one takes and how quickly the shift occurs, inflation can be viewed as either a good or a bad thing.
Individuals having tangible assets priced in currency, like as real estate or stored commodities, may prefer to see inflation since it enhances the price of their assets, allowing them to sell them at a higher price. Buyers of such assets, on the other hand, may be unhappy with inflation because they will have to pay more money. Another popular way for investors to profit from inflation is to buy inflation-indexed bonds.
People who own assets denominated in currency, such as cash or bonds, may, on the other hand, dislike inflation because it reduces the real worth of their possessions. Inflation-hedged asset classes, such as gold, commodities, and real estate investment trusts, should be considered by investors wanting to protect their portfolios from inflation (REITs).
Inflation encourages firms to invest in risky ventures and people to invest in company stocks because they expect higher returns than inflation. An optimum degree of inflation is frequently suggested in order to encourage spending rather than saving. If money’s purchasing power declines with time, there may be a stronger incentive to spend now rather than save and spend later. It has the potential to raise expenditure, hence boosting a country’s economic activity. A well-balanced method is thought to keep inflation in a desirable and optimal range.
Inflationary rates that are both high and fluctuating can wreak havoc on an economy. In their buying, selling, and planning decisions, businesses, workers, and consumers must all account for the effects of generally rising prices. This adds to the economy’s uncertainty by raising the possibility that they will be mistaken about the rate of future inflation. Time and resources spent investigating, estimating, and changing economic behavior are projected to rise in line with the general level of prices, rather than genuine economic fundamentals, resulting in a cost to the overall economy.
Because of how, where, and when new money enters the system, even a low, stable, and easily foreseeable rate of inflation, which some consider otherwise desirable, can cause major issues in the economy. When new money or credit enters the economy, it always ends up in the hands of specific individuals or businesses, and the process of price level adjustment to the new money supply continues as they spend it and it flows from hand to hand and account to account throughout the economy.
It raises some prices first and then raises other prices along the road. Because of this sequential shift in purchasing power and prices (known as the Cantillon effect), inflation not only raises the overall price level over time, but also distorts relative prices, wages, and rates of return. Economics in general realize that pricing distortions away from their economic equilibrium are bad for the economy, and Austrian economists believe that this process is a significant driver of economic recession cycles.
The financial regulator of a country is responsible for keeping inflation under control. It is accomplished through the use of monetary policy, which refers to the activities taken by a central bank or other committees to determine the amount and rate of expansion of the money supply.
The Fed’s monetary policy aims in the United States include moderate long-term interest rates, price stability, and maximum employment, all of which are aimed at promoting a stable financial environment.
Long-term inflation targets are clearly communicated by the Federal Reserve in order to maintain a stable long-term rate of inflation, which is regarded to be advantageous to the economy.
Price stability, or an inflation rate that is relatively constant, allows businesses to plan for the future since they know what to expect. This, according to the Fed, will encourage maximum employment, which is determined by non-monetary factors that fluctuate over time and are hence vulnerable to change. As a result, the Federal Reserve does not set a fixed maximum employment goal, and it is mostly determined by employer evaluations. Maximum employment does not imply zero unemployment, because there is some instability in the labor market as people leave and start new occupations.
In dire economic conditions, monetary authorities may also adopt extraordinary steps. Following the 2008 financial crisis, the Federal Reserve in the United States kept interest rates near zero and pursued a bond-buying program known as quantitative easing. Some detractors of the program said it would lead to a surge in US currency inflation, however inflation peaked in 2007 and then slowly dropped over the next eight years. There are a number of complex reasons why quantitative easing did not lead to inflation or hyperinflation, but the most straightforward answer is that the recession was characterized by a strong deflationary environment, which quantitative easing aided.
As a result, policymakers in the United States have worked to limit inflation at roughly 2% every year.
Due to fears that deflation could take hold in the eurozone and lead to economic stagnation, the European Central Bank has pursued extensive quantitative easing, and certain locations have seen negative interest rates.
Furthermore, countries with higher rates of growth are better able to absorb higher rates of inflation. India’s goal is roughly 4% (with a maximum tolerance of 6% and a minimum tolerance of 2%), while Brazil aspires for 3.75 percent (with an upper tolerance of 5.25 percent and a lower tolerance of 2.25 percent ).
A period of 50 percent or greater monthly inflation is commonly referred to as hyperinflation.
Hedging Against Inflation is a term used to describe the process of hedging against
Stocks are said to be the best inflation hedge since the rise in stock values includes the effects of inflation. Because practically all modern countries add to the money supply by injecting bank credit into the financial system, much of the immediate influence on prices occurs in financial assets that are priced in currency, such as stocks.
There are also unique financial tools that can be used to protect investments from inflation. Treasury Inflation-Protected Securities (TIPS) are a low-risk Treasury instrument that is indexed to inflation and increases the principal invested by the percentage of inflation.
TIPS mutual funds and TIPS-based exchange-traded funds are also options (ETFs). You’ll almost certainly need a brokerage account to obtain access to stocks, ETFs, and other vehicles that can help you avoid the risks of inflation. Due to the wide range of stockbrokers available, selecting one can be a difficult task.
Gold is also thought to be an inflation hedge, though this does not always appear to be the case in the past.
Because all world currencies are fiat money, the money supply might swiftly expand for political reasons, causing fast price hikes. The most well-known example is the early-twentieth-century hyperinflation that hit Germany’s Weimar Republic. The victorious nations in World War I requested reparations from Germany, which could not be paid in German paper currency because it was devalued due to government borrowing. Germany sought to print paper currency, buy foreign currency with it, and pay its debts with it.
This policy resulted in a rapid depreciation of the German mark, which was accompanied by hyperinflation. German consumers responded to the cycle by trying to spend their money as quickly as possible, knowing that the longer they waited, the less valuable it would become. As more money invaded the economy, its value plunged to the point where people were putting practically worthless bills on their walls. In 1990, Peru experienced a similar predicament, as did Zimbabwe in 2007–2008.
What Are the Causes of Inflation?
Demand-pull inflation, cost-push inflation, and built-in inflation are the three basic sources of inflation. Demand-pull inflation occurs when there are insufficient items or services to meet demand, leading prices to rise.
On the other side, cost-push inflation happens when the cost of producing goods and services rises, causing businesses to raise their prices.
Finally, workers want greater pay to keep up with increased living costs, which leads to built-in inflation, often known as a “wage-price spiral.” As a result, businesses raise their prices to cover rising wage expenses, resulting in a self-reinforcing cycle of wage and price increases.
Is Inflation Beneficial or Harmful?
Inflation is typically thought to be damaging to an economy when it is too high, and it is also thought to be negative when it is too low. Many economists advocate for a low to moderate inflation rate of roughly 2% per year as a middle ground.
In general, rising inflation is bad for savers since it reduces the purchase value of their money. Borrowers, on the other hand, may gain since the inflation-adjusted value of their outstanding debts decreases with time.
What Are Inflation’s Consequences?
Inflation can have a variety of effects on the economy. For example, if inflation causes a country’s currency to depreciate, exporters will benefit since their goods will be more affordable when priced in foreign currencies.
On the other side, this might hurt importers by raising the cost of foreign-made goods. Inflationary pressures can also boost expenditure since customers will rush to buy things before their costs climb even more. Savings, on the other hand, may lose some of their real worth, restricting their potential to consume or invest in the future.