Inflation refers to a rise in the price of goods and services, leading to a decline in the purchasing powering of a particular currency. In short, inflation means you won't be able to buy as much with your money.
So long as it occurs within reason, inflation can be helpful for an economy. But when it spirals out of control and becomes hyperinflation, meaning that rates of inflation exceed 50 percent during any given month, it can result in significant economic damage that takes time to repair.
Read on to learn more about inflation, its types, how it is measured, and a list of real-world examples.
What is inflation?
Inflation is the direct opposite of deflation, which is a prolonged decline in prices.
When a nation's currency loses its value, it isn't worth as much as before, and therefore consumers are unable to purchase as many goods and services with it. This leads to a deceleration in economic growth.
To manage inflation rates, federal financial authorities – usually banks – must take steps to address the supply of money in circulation.
The three types of inflation are demand-pull, cost-push, and built-in inflation. Read on for further details on each.
What creates inflation?
Any product and, by extension, any economic sector can experience inflation, whether it's the housing market, food or oil prices, utility prices, and even jewelry prices.
The most significant cause of inflation is an excess in the supply of money. This occurs when a government increases the production of money or gives more money away, mainly through loans.
Three categorizations exist for classifying the nature of inflation, and they are as follows:
Demand-pull inflation occurs when the money supply increases and contributes to a higher demand for goods and services. As a result, the economy cannot produce enough material to meet that demand, so prices skyrocket. More money in circulation means individuals will feel more confident in spending, which also increases demand.
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Cost-push inflation occurs when increased prices play a role in the commodities or raw materials market, which boosts the price of those materials. It costs more to fully develop each commodity – barrels of oil for our vehicles, for example – and that trickles down into the price that individual consumers pay.
Built-in inflation occurs when people expect inflation trends to continue into the near future, which, in turn, influences the relationship between wages and retail prices. Therefore, workers ask for higher salaries to balance out the high costs of producing and selling materials.
What are the effects of inflation?
Inflation is a far-reaching phenomenon and, consequently, gives rise to plenty of smaller events. Ultimately, the immediate effects of price increases depend on the specific type of inflation.
The cost of living
Higher prices require you to spend more not only on essential goods but on additional items as well, like sources of entertainment, clothing, and cellphones. Because of this, it can be more challenging to save money for retirement and emergencies.
Deceleration in economic growth
While economic inflation can help the market recover, if it climbs too high – as is the case if you're a consumer – businesses and business owners will be forced to hand over more money to keep production alive.
Exports and imports
Foreign exports usually benefit from inflation, as exporters can make their products more affordable on the international market. In contrast, importers can suffer as the cost of bringing in goods from neighboring countries grows steeper.
How do you measure inflation?
Statistical agencies are responsible for not only recording but analyzing inflation rates. In the United States, the Bureau of Economic Analysis and the Bureau of Labor Statistics are two such bodies. These agencies use what's called a pricing index to make accurate and verifiable measurements.
This pricing index is contingent on the goods and services under consideration and the type of inflation. Multiple indexes exist because investors are interested in different economic goods and services. That said, the Consumer Price Index and the Wholesale Price Index are the two most commonly used indexes.
The Consumer Price Index
Also called the CPI, this index evaluates the average price of a "basket of goods" that meets consumers' basic needs, including health care, transportation, and food.
Averaging the price of each "item" in the basket allows for CPI to be calculated. How these prices shift according to their relative weight, or prioritization, is also considered alongside a particular item's actual retail price.
This index helps in managing living cost fluctuations. Since 1913, the CPI has been reported each month by the U.S. Bureau of Labor Statistics.
The Wholesale Price Index
The Wholesale Price Index measures inflation based on the changes in the price of goods before they are made available to consumers. In other words, this index examines goods at the manufacturing level. Take cotton-based clothing, for example. The WPI records raw cotton prices, the yarn used to sew it together, and the final cost of that individual clothing item.
The Producer Price Index
The Producer Price Index, or PPI, is very similar to the WPI. Though most nations use the WPI, the U.S. frequently relies upon the PPI.
The PPI evaluates the average change in domestic retail prices over an extended period. More specifically, the difference between the seller's price and the buyer's price. The inflation value between two periods — say, two months — is determined through each of the three indexes with the following formula, although the CPI is the shining star here.
Percent of inflation rate = (Final CPI Index Value / Initial CPI Value) x 100
Two examples to understand what inflation looks like
German Weimar Republic
This is arguably the most famous example of hyperinflation.
In the 1920s, after the end of World I, Germany had to pay reparations to the winning Allied powers to atone for their actions on the world stage. German paper money would not be accepted, as its value was severely low due to the government's overspending during wartime. So, the country used its paper money to buy foreign currency, which resulted in an abrupt drop in the value of the German mark by way of rapid hyperinflation.
German citizens adopted frenzied spending habits to get rid of their worthless bills and flooded the market with cash, further devaluing their currency.
From 2007 to 2008, due to the political redistribution of agricultural land and a massive drought, the Zimbabwean economy nearly collapsed entirely. Inflation rates spiked violently, and the government's solution to printing more money backfired. As a result, inflation rates climbed far beyond that of 439 billion percent.
Is inflation bad for everyone?
Like its counterpart, deflation, inflation can be good or bad. It all depends on how extreme the phenomenon is.
Inflation leads to a rise in the price of commodities, allowing investors to sell them at a higher price and thus, earn a better profit. Buyers, however, are forced to spend more money to purchase these items.
Additionally, inflation can be detrimental to cash and bond assets, severely decreasing their inherent value.
Inflated prices encourage people to save more, which isn’t a bad thing, but that leads to less market activity, and businesses may suffer the aftershocks.
When inflation occurs, the economy is characterized by an atmosphere of uncertainty. Therefore businesses, employees, and customers alike must make adjustments when selling or purchasing to account for fluctuations.
How do policymakers deal with inflation?
Governing bodies are responsible for managing inflation rates and actively addressing them when they get out of hand. A standard solution is making alterations to monetary policy. In other words, governments must decide whether to increase or decrease the amount of money produced and circulated throughout the economy.
Stabilizing prices, standardizing interest rates, and achieving maximum employment levels have been long-term goals for the federal government. All three of these factors, alongside many others, contribute to a healthy economy.
Currently, U.S. policymakers have agreed to try and keep the annual inflation rate at two percent, in adherence to Federal Reserve guidelines.
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