Introduction

Have you ever heard your grandmother say that everything was cheap when she was young? The reason is inflation. This phenomenon is caused by irregularities in the supply and demand of products and services, which leads to price increases.

Inflation has its advantages, but in general, too much inflation is a bad thing: if your money is going to be worth less tomorrow, why save money? In order to control excessive inflation, governments around the world will deploy policies aimed at reducing consumption.

Contents

• Introduction
• Causes of Inflation
  • Demand-pull inflation
  • Cost-push inflation
  • Intrinsic inflation
• Inflation remedies Measures
  • Raise interest rates
  • Change fiscal policy
• Use price index to measure inflation
• Inflation Advantages and Disadvantages
  • Advantages of Inflation
  • Disadvantages of Inflation
• Summary

Introduction

Inflation can be defined as the decline in the purchasing power of a currency. That is, the price of goods and services in an economy continues to rise.

"Relative price changes" usually mean an increase in the price of just one or two goods, whereas inflation refers to an increase in the cost of nearly all goods in the economy. In addition, inflation is a long-term phenomenon, that is, price increases must be continuous and not just occasional events.

Inflation rates are measured annually in most countries. Typically, you see inflation expressed as a percentage change: that is, an increase or decrease relative to the previous period.

In this article, we will discuss the different causes of inflation, how to measure it, and the impact (both positive and negative) it can have on the economy.

Causes of inflation

At a basic level, we can draw two common causes of inflation Cause. First, the amount of real money in circulation (supply) increases rapidly. For example, when European colonists conquered the Western Hemisphere in the 15th century, gold and silver bars poured into Europe, causing inflation (excessive supply).

Secondly, inflation may also occur due to a shortage in supply of a specific commodity that is in high demand. This could then trigger an increase in the price of such goods, potentially spreading to other parts of the economy. The result could be a general increase in prices for nearly all goods and services.

But if we dig deeper, we find that there may be different types of events that lead to inflation. Here, we distinguish between demand-pull inflation, cost-push inflation and intrinsic inflation. There are other variations, but the above inflation is the main type in the "triangular model" proposed by economist Robert J. Gordon.

Demand-pull inflation

Demand-pull inflation is the most common type of inflation. The cause is increased consumption. In this situation, demand exceeds the supply of goods and services, and this phenomenon causes prices to rise.

To illustrate this point, consider a baker selling bread in a market. The baker makes about 1,000 loaves a week. This is a good run since he sells about this amount every week.

But suppose the demand for bread increases significantly. Perhaps economic conditions have improved, meaning consumers have more money to spend. Therefore, we are likely to see an increase in the price of bread sold by bakers.

Why? Because when we make 1,000 loaves of bread, our bakers are at full capacity. Neither his staff nor his ovens could actually produce more than that. He could install more ovens and hire more workers, but it would take time.

It’s too late now, we have too many customers and not enough bread. Some customers are willing to pay more for bread, so it's natural for bakers to increase their prices accordingly.

Now, in addition to the increased demand for bread, imagine that improving economic conditions also lead to increased demand for milk, oil, and several other products. This is the definition of demand-pull inflation. People are buying more and more goods, causing supply to exceed demand and causing prices to rise.

Cost-push inflation

When increases in raw material or production costs cause the price level to rise, Cost-push inflation will occur. As the name suggests, this type of cost is "pushed" to consumers.

We return to the previous situation with the baker. He installed new ovens, hired additional workers, and was able to produce 4,000 loaves a week. For now, supply meets demand, and everyone is happy.

One day the baker heard some sad news. The wheat harvest has been particularly bad this season, which means all bakeries in the region are short of supplies. The baker must pay more for the wheat needed to produce the bread. With this additional expenditure, he needed to increase the prices he charged, but consumer demand did not grow.

Another possibility is that the government raises the minimum wage. This increases the baker's production costs and, therefore, he has to increase the price of his existing bread again.

From a macro perspective, cost-push inflation is usually caused by shortages of resources (such as wheat or oil), increased government taxes on goods, or falling exchange rates (leading to higher import costs).

Inherent inflation

Inherent inflation (also known as inertial currency Inflation) is a type of inflation caused by past economic activity. Therefore, if the first two forms of inflation persist over time, this type of inflation may be triggered. Intrinsic inflation is closely related to inflation expectations and the concept of rising prices and wages.  

The first concept in the above argument is that after experiencing a period of inflation, individuals and businesses expect that inflation will persist in the future. If inflation occurs in previous years, employees are more likely to negotiate for raises, causing businesses to charge more for their products and services.

The concept of spiraling prices and wages illustrates the tendency of inherent inflation to lead to increased inflation. This may occur when an employer and worker cannot agree on the value of wages. While workers are demanding pay rises to protect their wealth from expected inflation, employers are being forced to raise the cost of their products. This can lead to a self-reinforcing cycle in which workers respond to rising costs of goods and services by demanding further wage increases, and the cycle continues.

Remedies for Inflation

Uncontrolled inflation can be damaging to the economy, so governments are inevitably taking a proactive stance to limit its impact. The government can do this by adjusting the money supply and changing monetary and fiscal policies.

Central banks (such as the Federal Reserve) have the power to change the fiat currency supply by increasing or decreasing the amount in circulation. A common example is quantitative easing (QE), where a central bank purchases bank assets to inject newly printed money into the economy. This measure can actually increase inflation and should not be used when inflation is an issue.

The opposite of quantitative easing is quantitative tightening (QT), a monetary policy that reduces inflation by reducing the money supply. However, there is little evidence to support QT as a cure for inflation. In practice, most central banks raise interest rates to control inflation.

Raise interest rates

Higher interest rates make it more expensive to borrow money. As a result, credit becomes less attractive to consumers and businesses. At the consumer level, rising interest rates will discourage consumption, resulting in less demand for goods and services.

Saving is more attractive during times like this, and for people who earn interest on borrowed money, that's an even better thing. However, economic growth may be limited as businesses and individuals become more cautious when borrowing to invest or spend.

Altering fiscal policy

While most countries use monetary policy to control inflation, But changing fiscal policy is also an option. Fiscal policy refers to changes in consumption and taxation made by the government to influence the economy.  

For example, if the government increases the amount of income tax it collects, individuals' disposable income will decrease again. This would in turn reduce demand in the market, which should theoretically lower inflation. However, this is a risky move because of the risk that the public will react adversely to higher taxes.

Measuring inflation using price index

We have outlined various measures to deal with inflation, but How can we effectively recognize the need to fight inflation in the first place? Obviously, the first step is to measure inflation. Typically, measurement is accomplished by tracking an index over a set period of time. In many countries, the Consumer Price Index, or CPI, is the preferred measure of inflation.

The CPI takes into account the prices of a variety of consumer goods, using a weighted average to value the basket of goods and services purchased by households. This is done at regular intervals and the score can then be compared to historical scores. Entities such as the U.S. Bureau of Labor Statistics (BLS) collect this data from stores across the country to ensure that calculations are as accurate as possible.  

You may see in the calculation a CPI score of 100 in the "base year" and then a score of 110 two years later. You can then conclude that prices have increased by 10% over two years.

A small amount of inflation is not necessarily a bad thing. This is a natural phenomenon in today’s fiat currency system, and has certain benefits since inflation encourages spending and borrowing. However, to ensure that inflation does not have a negative impact on the economy, it is crucial to keep a close eye on inflation rates.

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Pros and Cons of Inflation

At first glance, inflation seems entirely worth avoiding . But it's still part of the modern economy, so inflation is a more subtle subject in reality. Let’s look at the pros and cons of inflation.

Advantages of inflation

Increased consumption, investment and borrowing

As we have seen before As mentioned above, a slight inflation rate can benefit the economy by stimulating consumption, investment and borrowing. Since inflation causes the same amount of cash to have less purchasing power in the future, it makes more sense to buy goods or services now.

Increase profits

Inflation encourages companies to sell their goods and services at higher prices to protect themselves from the effects of inflation. They have valid reasons for raising prices, but they may also raise prices slightly higher than necessary to make extra profits.

This is better than deflation

We can easily infer from the name that deflation is the antonym of inflation, which is characterized by price increases. Decrease over time. Since prices are falling, delaying purchases makes more sense for consumers because they can get better deals in the near future. This can have a negative impact on the economy because goods and services are not in as much demand.  

Historically, periods of deflation have led to rising unemployment and a shift toward saving rather than spending. While this is not necessarily a bad thing for individuals, deflation tends to hinder economic growth.

Disadvantages of inflation

Currency devaluation and hyperinflation

Finding the right inflation rate is not easy, and getting out of control can have disastrous consequences. Ultimately, this phenomenon eats away at the wealth held by individuals: If you hide $100,000 in cash under your mattress today, that money will have far less purchasing power in ten years.

High inflation can lead to hyperinflation, which is said to occur when prices rise by more than 50% in a month. Spending $15 on a basic necessity that only cost $10 a few weeks ago isn't a great deal, but hyperinflation rarely stops there. During periods of hyperinflation, price inflation often exceeds 50%, essentially destroying the currency and economy.

Uncertainty

If inflation is high, uncertainty will dominate. Individuals and businesses are uncertain about the direction of the economy and will therefore use funds more cautiously, which can lead to less investment and slower economic growth.

Government Interventionism

Some people oppose the idea of government trying to control inflation, citing free market principles. They believe that the government's ability to "print more money" (or "Printing machine, go!" as it is known in cryptocurrency circles) undermines natural economic principles.

Summary

The impact of inflation is so great that we see prices rising over time, This has led to an increase in the cost of living. We have come to accept this phenomenon, after all, if controlled properly, inflation can be good for the economy.

In today's world, the best remedy seems to lie in flexible fiscal and monetary policies, which allow governments to make adjustments to curb rising prices. However, such policies must be implemented with caution or they may end up causing further damage to the economy.