What is Inflation? What are The Types of Inflation and its Effects?
Ever since the invention of money, there have been debates about inflation. Many of us see inflation as an ongoing increase in prices but in fact, an increase of prices is one of the effects of inflation.
Basically, inflation is the decline of purchasing power of a currency due to continuous increase of the prices of goods and services. A unit of currency effectively buys less than it did in the prior periods which is the ground for the rise in prices. The indicator of inflation is not the increase of prices in certain goods. We can talk about inflation when there is a continuous increase in the prices of goods and services altogether.
Decrease in inflation doesn’t mean that purchasing power will increase. The overall impact of price changes for a number of products and services is measured by inflation. Also, we can say that, in an economy inflation is the single value representation of the increase in the prices of goods and services (over a period of time).
Inflation affects everyone but is difficult to predict, which is why it is considered a mysterious economic force. In fact, inflation is a response to a few key factors in the economy. There are two main causes for inflation: demand-pull and cost-push. These two are responsible for a general rise in prices however, each puts pressure on prices in a different way. When demand from consumers pulls prices up, the conditions for demand-pull occur. And when supply costs force prices higher, cost-push occurs. There’s an ongoing debate about a third cause for inflation: expansion of the money supply. But over time, the relationship of money supply to inflation has decreased and it is no longer a cause on its own.
How is Inflation Measured?
The most common way of measuring inflation is by looking at the change in the consumer price index. The CPI (consumer price index) shows how much it costs to live at a place and how this cost has developed over time. CPI has a direct impact on the lives of people. Wages, state pensions and specific duties and taxes, and rental contracts can all be modified to some extent according to the variations in the CPI. For example, the goal pursued by the central banks is to maintain price stability. In order to formulate monetary policies, it is crucially important to measure the evolution of inflation accurately. Surely you have seen the percentages and percentage values in news programmes or financial news clips about measuring inflation.
We can measure inflation in different ways based on types of goods and services. Inflation is the opposite of deflation which means a general decline in prices. Let us take a look at this example to make sense of these percentages.
Types of Inflation
Every country has an economy and economic power unique to itself and each country is different from one another in these terms. Thus, inflation is experienced differently in every country. Types of inflation are categorised in two separate ways depending on the gravity and the grounds of it.
Moderate inflation, high inflation and hyperinflation are the types of inflation in terms of gravity. Demand-pull inflation, cost-push inflation and built-in inflation are the types of inflation in terms of ground.
Moderate inflation is the type of inflation with less damaging effects as the name suggests and it means the increase in prices is somewhat reasonable.
High inflation is when the prices of goods and services are increasing rapidly and the purchasing power is decreasing continuously. In an economy where there is high inflation, the currency of the country also loses value rapidly.
Naturally, one would hate rising prices as a consumer. However, it is believed by many economists that a moderate amount of inflation is healthy and necessary for the economy of a nation. But of course, if or when the inflation rises rapidly out of control and the nation’s own currency loses value, an environment for hyperinflation will occur and it has devastating effects on many levels for a country. In some cases, countries end up changing their currency.
Sometimes overall demand for goods and services in an economy is stimulated by the increased supply of money and credit. This creates demand-pull inflation because the stimulation is being used as a tool to grow rapidly than the economy's production capacity. Then the demand is increased and this directly leads to price increases. For instance, in an environment where 10 people consume 10 loaves of bread daily, the production of bread goes down to 8. This means the price of bread will increase and this an example for demand-pull inflation.
When the manufacturing costs (costs of the factors of production) increase, the result is cost-push inflation. Manufacturers are naturally inclined to maintain their profit margins but the rising production costs make it impossible. They are almost forced to increase the prices of these goods. This means consumer prices are pushed up by production costs.
Built-In inflation occurs when the prices of commodities in a nation are increasing and then labour demands higher wages to keep up with or maintain their standards of living due to the higher costs of finished products. Rise in the general population or migration make demand spike and the production is nowhere near to meet the demand, this is one of the reasons for built-in inflation.
Ramifications of Inflation
We must mention the ramifications of inflation where it is being experienced. When inflation is on the rise, it’s more expensive to purchase goods and services. But feeling the pinch on our wallets is not the only effect of inflation.
The major trend impacts the economy in several different ways. Inflation erodes the purchasing power. It hurts the poor disproportionately. Inflation means raised interest rates. When we consider things in the short term, it’s possible that high inflation can lead to faster economic growth. Remember in the US, the 1970s were recalled as the decade of stagflation, but US gross domestic product (GDP) increased by 3% annually on average between 1970 and 1979.
This figure was well above the economy’s average growth rate. However, inflation can also cause painful recessions. When a representative basket of goods and services becomes increasingly more expensive, this is usually caused by the decline of the purchasing power of a currency. This is the direct consequence of inflation. As the purchasing power decreases some structural changes are likely to be observed. Also, we might see changes in people’s behaviour. Let us take a look at these possibilities.
Individuals in the system lose their purchasing power which might cause serious social unrest. Working class and civil servants are the ones who are severely affected by inflation because it is very difficult to increase salaries in accordance with the inflation rate.
People who have debt in the currency of the country will benefit from inflation as the loss in value allows them to pay their debts relatively easier.
People lose interest in having savings accounts and saving money because it becomes more reasonable to invest in goods or real estate as the inflation rate rises. This, of course, will result in demand. When the demand increases the prices also rise.
Fair income distribution becomes a much harder matter to resolve.
As we mentioned above, a reasonable and positive inflation rate is quite useful, even healthy for an economy. But high inflation will feed on itself and the long-term performance of any economy will be crippled by high inflation. It’s true that during periods of high inflation, real estate, value stocks and energy commodities have outperformed but we must remember how purchasing power is eroded by the sustained and large rise in the prices of goods and services. It is time to be prepared.