What is inflation and why do prices keep going up?

Inflation is, paradoxically, both incredibly simple to understand and absurdly complicated. In a market economy, products and services prices are always changing: some prices rise, some prices fall. Inflation occurs if there is a broad increase in the products and services prices, meaning that you can buy less for €1 today than you could yesterday. In other words, inflation reduces the value of the currency over time. While it is easy to measure the price changes of individual products over time, human needs extend beyond one or two such products or services and measure the overall impact of price changes for a diversified set of products and services (like food, metal, fuel, utilities like electricity and transportation, and services like healthcare, entertainment and labor). In this article learn what is inflation, why is happening and what impacts has on individuals and economies.

What is inflation and why do prices keep going up?

Firstly, what is inflation?

Inflation is the rate of prices increase over a given period of time. In other words, inflation is the rate at which the value of a currency is falling and, consequently, the general level of prices is rising.

Whatever the context, inflation represents how much more expensive the relevant set of products and/or services has become over a certain period, most commonly a year.


What Causes Inflation?

There are three main causes of inflation:

  1. 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. In other words, inflation is caused by strong consumer demand for products or services.
  2. cost-push inflation: occurs when prices increase due to increases in production costs, such as raw materials and wages. As a result, the added costs are passed onto consumers in the form of higher prices for the products or services.
  3. built-in inflation (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.


How Inflation is Measured?

The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.

In the U.S. the CPI is based on the shopping diaries of 24,000 people and constructed each month using 80,000 items in a fixed basket of goods and services representing what Americans buy in their everyday lives (this includes a wide range of items such as food, televisions, prescription drugs, rent or gasoline). The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens.


The CPI basket is mostly kept constant over time for consistency, but is tweaked occasionally to reflect changing consumption patterns (for example, to include new hi-tech goods and to replace items no longer widely purchased).

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.


What are the effects 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.

For example, individuals with tangible assets that are priced in currency, like property, inventory, equipment or vehicles, may like to see some inflation as that raises the price of their assets, which they can sell at a higher rate. However, the buyers of such assets may not be happy with inflation, as they will be required to shell out more money.


Too much inflation is generally considered bad for an economy, while too little inflation is also considered harmful.

Generally speaking, higher inflation harms savers because it erodes the purchasing power of the money they have saved. On the other hand, a borrower who pays a fixed-rate mortgage of 5% would benefit from 5% inflation, because the real interest rate (the nominal rate minus the inflation rate) would be zero.

But, you will not benefit from inflation if carrying debt with a variable interest rate.

Many economists advocate for a middle-ground of low to moderate inflation, of around 2% per year.


How high can inflation be?

Inflation that reaches 50% a month is called hyperinflation. It occurs when the government essentially prints money without regard to the inflation rate. Many countries have grappled with high inflation and in some cases hyperinflation, 1,000 % or more a year.


The most widely studied hyperinflation occurred in Germany after World War I, reaching a inflation rate of approximately 29,500 % in October 1923. This huge number amounts to a monthly inflation rate of 322 %. On average, prices quadrupled each month during the sixteen months of hyperinflation.

While the German hyperinflation is better known, a much larger hyperinflation occurred in Hungary after World War II. Between August 1945 and July 1946, the general level of prices rose at the astounding rate of more than 19,000 % per month, or 19 % per day.

In 2008, Zimbabwe experienced one of the worst cases of hyperinflation ever, with estimated annual inflation at one point of 500 billion %, with prices almost doubling every 24 hours.


Such high levels of inflation have been disastrous, and countries have had to take difficult and painful policy measures to bring inflation back to reasonable levels, sometimes by giving up their national currency, as Zimbabwe has.


What’s happening with prices today? Has the COVID Pandemic impacted inflation?

The ongoing pandemic has played a leading role in the jump in inflation as long-lasting COVID-induced supply chain disruptions have made it difficult to find some items while driving up consumer prices.

Temporary disruptions were widespread and easy for consumers to observe in the empty shelves and "product temporarily unavailable" notices that were prevalent at the outset of the pandemic.


As previously stated, we can say that COVID inflation is demand-pull inflation, meaning that there are not enough products to keep up with demand, but also cost – push inflation, meaning that production costs are increasing due for example disruptions in transport of raw material. As a result, we have a continuous price increase.


Is it possible that there is no inflation? Wouldn't it be good if prices were always low?

Is it possible? Yes. Is it good? Sometimes.

The fear is that if prices are not going up, they are going down. In that case, you are dealing with deflation. Imagine you took a loan to buy a house, and then every year its value goes down instead of up. That means every year, your debt gets bigger and bigger.

However, most of the time, deflation is unambiguously a positive trend for the economy, because general decrease in prices gives consumers greater purchasing power.


Conclusion:

The concept of inflation is closely related to the assessment of living standards and the “cost-of-living”.


Most economists now believe that low, stable, and, most important predictable inflation is good for an economy. If inflation is low and predictable, it is easier to capture it in price-adjustment contracts and interest rates, reducing its distortionary impact. Moreover, knowing that prices will be slightly higher in the future gives consumers an incentive to make purchases sooner, which boosts economic activity. Many central bankers have made their primary policy objective maintaining low and stable 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.


And don’t be scared, if inflation ever approaches hyperinflation, your best defense is to buy gold and other precious metals. Gold is a real, physical asset, and tends to hold its value for the most part.


References

WEB: The IMF - Ceyda Oner, / ... https://www.imf.org/external/pubs/ft/fandd/basics/30-inflation.htm
WEB: Investopedia - Jason Fernando, / ... https://www.investopedia.com/terms/i/inflation.asp
WEB: Investopedia - THE INVESTOPEDIA TEAM, / ... https://www.investopedia.com/ask/answers/111314/what-causes-inflation-and-does-anyone-gain-it.asp
WEB: CNN Business - Allison Morrow, / ... https://edition.cnn.com/2021/11/13/economy/what-is-inflation-explainer/index.html
WEB: European Central Bank - /, / ... https://www.ecb.europa.eu/ecb/educational/hicp/html/index.en.html
WEB: Investopedia - THE INVESTOPEDIA TEAM, / ... https://www.investopedia.com/ask/answers/111314/what-causes-inflation-and-does-anyone-gain-it.asp
WEB: The Brookings Institution - Nasiha Salwati; David Wessel, / ... https://www.brookings.edu/blog/up-front/2021/06/28/how-does-the-government-measure-inflation/
WEB: The Balance - Kimberly Amadeo, / ... https://www.thebalance.com/inflation-impact-on-economy-3306102
WEB: Nationwide Economics - /, / ... https://blog.nationwidefinancial.com/markets-economy/how-has-the-pandemic-impacted-inflation/
WEB: EconoFact - Alberto Cavallo and Oleksiy Kryvtsov, / ... https://econofact.org/pandemic-shortages-and-inflation-from-empty-shelves-to-higher-prices

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