Consumers are used to experiencing incremental price increases across a vast array of goods and services. Economists use the term “inflation” to measure and describe these increases and their impact on the economy, such as reduced purchasing power for consumers.
For instance, in the United States, the price of a cup of coffee or a tank of gas has increased exponentially since the 1970s, meaning people need to spend more dollars to buy the same amount of coffee or gas.
The opposite effect of inflation is deflation, when prices go down, and consumer purchasing power increases.
Understanding inflation
Inflation is affected by factors under the relatively direct control of governments and central banks, such as the supply of money, interest rates, and fiscal policies such as taxation. However, it can also be affected by areas outside their control such as technological progress and demographic shifts (such as an ageing population).
Measuring inflation
Inflation is measured using a price index that averages the price for various goods and services, such as the Consumer Price Index (CPI). The CPI tracks the average retail price of a basket of goods and services used by the average urban consumer and is generally considered a reasonable proxy for changes in the cost of living.
While often cited as a single simple metric, inflation impacts many areas of the economy and financial system in various, potentially complex ways. For example, inflation accounts for price changes in the food supply chain, commodities (such as metals and energy), the global supply and demand for goods and services, and factors such as the cost of labor and transportation.
Other indices measure the effect of inflation in other areas of the economy, such as wholesale prices of goods and services before they reach retail consumers.
Economists track the rate of inflation by calculating the difference between the value of a price index at two points in time, expressed as a percentage.
Using a hypothetical example, if the CPI in 1980 was 75, and in 2020 it was 250, then the inflation rate over 40 years is calculated as:
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛=(𝐶𝑃𝐼2020-𝐶𝑃𝐼1980)/𝐶𝑃𝐼1980 * 100 = ((250-75)/75) * 100 = 233.33%
Of note, inflation is typically a year-on-year metric, but is represented as a cumulative percentage when measuring inflation over the years.
What causes inflation?
Economist Robert J. Gordon created the “triangle model,” which simplifies the causes of inflation into three scenarios: demand-pull, cost-push, and built-in inflation.
Demand-pull
Demand-pull inflation describes the situation where the increased purchasing power of consumers causes an increased demand for goods or services at a rate faster than the market can supply them.
For instance, the sudden onset of the Covid-19 pandemic along with governmental response measures caused considerable changes in people’s buying habits, creating high demand in segments such as home, garden and hobby products. In many cases, this spike in demand led to price increases.
Cost-push
Cost-push inflation occurs when the raw materials needed to produce goods or provide services increase in price, typically due to scarcity.
An example of cost-push inflation is the global increase in energy prices resulting from the Russia-Ukraine war that began in 2022. However, it’s more common for cost-push increases to result from factors such as increased labor costs.
Built-in
Built-in inflation, also called hangover inflation, results from past periods of inflationary activity. It commonly occurs after high inflation when people expect prices to continue rising at a fast rate. During these times, workers may continue to negotiate higher wage increases, which puts further upward pressure on prices.
Government intervention in inflation
Governments typically do not directly set the prices of goods and services, but they can adjust consumer purchasing power by raising or lowering taxes. However, a more common practice in worldwide economies is to manage inflation by adjusting interest rates, usually conducted by the jurisdiction’s central bank.
Increasing interest rates makes it more expensive to borrow money and more attractive to save money. This helps curb inflation by decreasing purchasing power and encouraging saving. Conversely, governments or their central banks may cut interest rates to encourage borrowing and spending.
Further, governments can theoretically have an impact on increasing inflation when they increase the amount of circulating currency, a practice known as quantitative easing (QE). This is because, as more money enters the market, the purchasing power of the circulating money declines.
Advantages and disadvantages of inflation
Inflation is not generally regarded as a negative because it plays an important role in helping stimulate the economy. Typically, the year-on-year inflation rate aims to target a 2% change, and any deviation from that number can be seen as problematic. Inflation can be also viewed as an advantage thanks to its ability to account in part for returns on investments such as real estate and stocks.
However, inflation can be a disadvantage if prices rise too quickly, contributing to consumers being priced out of the market. Another disadvantage occurs when reporting inflation numbers, because it reflects an average of goods and services rather than tracking a single category. While CPI is used in the traditional finance sector, for a more accurate number representing how consumers are affected, they should be looking at inflation within specific categories.
Inflation essentials
- Inflation is the measure of the rate of increase in the consumer cost of living
- Inflation is a result of global market forces of supply and demand, as well as government monetary and fiscal policy