Inflation: Understanding What Inflation Is And What Causes It

Written by experts Pat Collins and John Halloran.

Table of Contents

1. Introduction To Inflation
2. Understanding The Causes Of Inflation
3. The Cost Of Inflation
4. Defining Various Types Of Inflation
5. Understanding How Inflation Works
6. Summary

No. 1: Introduction to Inflation

Inflation could be defined as the decline of a given currency’s purchasing power over time. This means there’s been a steady increase in the general level of prices in an economy for goods and services. 

When there’s a decline in purchasing power, a measurable estimate of the rate at which this occurs can be demonstrated by the increase of the average price level of a basket of specifically chosen goods and services. This will be calculated in an economy over a certain period of time.

Inflation is measured as an annual change in percentage. An increase in the general level of prices, typically expressed as a percentage, means that your dollar buys less than it did before. You have inflation when prices rise and the value of money falls.

Of course it’s not difficult to measure price changes between two separate products over a period of time, but human needs go way beyond just a couple of products. To live a comfortable life, people require a large, diversified group of products, in addition to a wide range of services. This includes fuel, metal, food grains, utilities like transportation and electricity, labour, and services such as entertainment and healthcare. The real aim of inflation is to measure the total effect of price changes over an extensive range of services and products. A single value representation of the price level increases of goods and services is determined in an economy over a specific period of time.

‘Purchasing power’ is the value of any unit of money; it’s the amount of actual services or real, tangible goods that can be purchased at a moment in time. 

There’s a decrease in the purchasing power of money when inflation goes up. Let’s say there’s an annual inflation rate of 2%; in theory, a $1 item will cost $1.02 in a year. Your dollar does not last as long as it did in the past, after inflation. This explains why this same item cost only $0.05 back in the 1940s – the price of the item has increased, or to put it another way, the value of the dollar has fallen. Most developed countries have tried to maintain a 2 – 3% inflation rate in recent years, using the same monetary policy tools used by central banks. This type of monetary policy is referred to as inflation targeting.

No. 2: Understanding the Causes of Inflation 

Universally, economists and academics are still unable to agree why inflation occurs, but there are some commonly held hypotheses. Some believe that the root of inflation is an increase in the supply of money. Money supply can be increased by –

• legally devaluing the legal tender currency,
• monetary authorities printing and giving away more money, or
• purchasing government bonds from banks on the secondary market and

lending new money into the system as reserve account credits through the banking system.

Money loses its purchasing power in all the above cases of increases in money supply.

Inflation is driven by three types of mechanisms – these are demand-pull inflation, cost-pull inflation, and built-in inflation. Let’s take a closer look at these –

Demand-Pull Inflation

We see demand-pull inflation when there’s an overall increase in demand for goods and services, which ultimately lifts their prices. This typically occurs in fast growing economies – too few goods being chased by too much money. Prices increase if demand grows faster than supply. The Keynesian school of economics often promotes this theory.

Cost-Push Inflation 

Cost-pull inflation follows price increases in production. This occurs when companies are forced to increase their prices to sustain their profit margins. Cost increases might include things like the increased costs of imports or natural resources, taxes, and wages.

Built-In Inflation

Built-in inflation is caused by expectations of future inflation. What does this mean? When prices continue to rise, workers expect to receive higher wages to maintain a certain lifestyle, but this leads to higher prices, and so the spiral begins. This circular dependency is also known as the wage-price spiral. It should be noted that the expectations that create built-in inflation always stem from significant cost-pull or persistent demand-pull inflation in the past. Thus, built-in inflation always requires a trigger or catalyst to kick it off – it doesn’t occur on its own.

No. 3: The Cost of Inflation

People are affected in different ways by inflation; some people benefit from the effects of inflammation, often at the expense of those who miss out. This is also determined by whether inflation rate changes are expected, or unexpected. If the rate of inflation conforms to what most people anticipate, or expect, the impact of inflation is not necessarily as severe and people can compensate. Banks can change interest rates, and employees can renegotiate wages and salary contracts to include automatic wage increases as prices escalate.

The following is a summary of inflation winners and losers –

• Under inflation, lenders (creditors) lose and borrowers (debtors) gain. For our example we’ll assume your bank approved a 30-year mortgage to purchase a new house. The interest rate is fixed at 5% per year and costs $1,000 per month. With a rise in inflation, that $1,000 per month will decrease, thus benefiting the homeowner. This is especially true if the rate of inflation surpasses the interest rate of the home loan.
• Savers are hurt by inflation because every dollar you save will have less value in the future. The buying power of your savings will reduce, unless you have the money in an account that attracts an interest rate at or above the inflation rate. This is what’s often referred to as ‘cash-drag’.
• Employees with contracts or fixed salaries that are not adjusted with inflation are hurt because the buying power of their income stays the same while prices continue to rise.
• People who live off a fixed income, like retirees or annuitants and those who live below the poverty line, will notice a reduction in both their purchasing power and their standard of living.
• Landlords benefit from inflation because they have the ability to raise rent payments each year.
• Economic output is negatively affected due to uncertainty about the future, making consumers and corporations less likely to spend.
• Domestic products become less competitive if the domestic inflation rate is higher than in other countries.
• Repricing costs, like price lists, menus, labels, and so much more have to be updated, so the entire economy is forced to absorb these costs.

No. 4: Defining Various Types of Inflation

When discussing inflation, we can see there are several variations, namely Deflation, Disinflation, Hyperinflation, and Stagflation.

Deflation 

Deflation is the opposite effect of inflation; it’s when there’s falling general levels of prices. Deflation typically occurs for shorter periods of time, and more rarely than inflation. It usually occurs during times of economic crisis or recession, and can result in a serious economic crisis, even depression. This is due to what’s known as the deflationary spiral. 

Why would you spend today when your money will have more value tomorrow, and why would you spend your money tomorrow when it will go further the next day? What happens is that people hoard their money; they stop spending, hoping prices will continue falling. Hoarded money is not being spent, resulting in the collapse of business profits, and staff are laid off. Unemployment increases, leaving the economy with a big reduction in spending, and so the spiral continues.

Disinflation

Disinflation refers to where there’s still positive inflation; however, there’s a decreasing rate of inflation, like from +3% to +2%.

Hyperinflation 

Hyperinflation refers to abnormally rapid inflation, usually in excess of 50% in a one month period. In extreme situations, this rapid inflation rate can cause a breakdown in the monetary system of a nation, or even a breakdown in its economy.

In Germany, in 1923, we saw one of the greatest examples of hyperinflation, when prices increased by 2,500% in just one month! A similar situation occurred in Zimbabwe where hyperinflation led to the printing of Z$100 trillion bills that were only worth a few US dollars. In the 20^th century we saw hyperinflation occur in both Argentina and in Hungary.

Stagflation 

Stagflation refers to the unusual combination of economic stagnation and high employment, together with high inflation rates. This occurred during the 1970s in industrialized countries, when OPEC raised oil prices in a rocky economy, causing a demand shock for oil. The result was that, even with a slackening economy, the price of oil and all products and services that use oil as an input, were sent higher.

No. 5: Understanding How Inflation Works

When prices go up, people complain, but they forget the fact that wages should also be going up. It’s not really a question of whether inflation is rising or not, it’s whether inflation is rising at a pace that’s quicker than your wages. 

• A modest inflation shows a growing economy. 
• Sometimes, little inflation can be as damaging as high inflation. 
• Lack of inflation could well indicate a weakening economy.

You can see from the above points that it’s difficult to label inflation as good or bad – it really depends on your own personal situation, the overall economy, and how fast the change occurs.

No. 6: Summary
Inflation can be described as an escalation in the price levels of services and goods in an economy over a certain period of time. The three types of inflation are demand-pull, cost-push, and built-in inflation.  ‘Demand-pull’ occurs when the demand for services or goods grows quicker than the economy’s production capacity; ‘cost-push’ is due to a rise in production costs, and ‘built-in’ is created due to the public’s expectations of inflation in the future.