Inflation

Definitions

Inflation: The general and sustained rise in the levels of prices of goods and services. It is expressed as a rate of change per period of time (usally per month or year)
Hyperinflation: Too high inflation where money becomes almost worthless

How to measure inflation

To measure inflation accurately, it is necessary to calculate the average percentage change in prices of ALL goods and services in an economy. This is obviously a very hard task, because there are too many to be able to take them all into account in such a short period of time. This is why goods and services are often grouped in "baskets", which contain typical products for specific categories, such as food, entertainment, etc. The results of these average prices make up the CPI (Consumer Price Index) or RPI (Retail Price Index), which is then used to calculate the total inflation in an economy. Using different categories allows us to see in which areas of the market there is more inflation.

How to calculate a price index

The first year when the total price of a basket is calculated is called the "base year" and its value will be 100. Then, after calculating in the following years, if the prices in same basket rise by 25%, the basket price will be 125. Then, if the next year the prices increase by 10%, the total price of the basket will be calculated using the following formula:
Basket Price = Previous Basket Price x (1 + Increase in decimal)
In this case, the basket price for the year would be 125 times 1.10 which would equal 137.5, meaning that there was a 37.5% inflation from the base year.

What causes inflation?

Usually, the main cause of inflation is too much money for customers to spend and too few goods that these customers can buy because prices have gone up due to the high money supply. The excess in aggregate demand also causes the prices to rise. A government can allow the money supply to rise to fix this problem to increase demand in the economy and reduce unemployment, to fix the excessive demand for goods and services, and to respond to the worker's demands for higher wages. When the money supply expands, the people will have more money, and because the prices have previously gone up, they will now be able to buy the same as the previous year with more amount of money. The real value of money is the how much goods and services money can buy. Inflation makes this real value drop and more money is needed to buy the same thing.

Types of inflation

Demand-pull inflation

When inflation is caused by an increase in demand, it is called demand-pull inflation. In an economy, this would happen if spending increases. This will cause prices of goods and services to increase. Inflation will also rise if the firms cannot produce enough goods to satisfy all the demand.

Cost-push inflation

Another cause for prices to rise is that costs are too high for the firm to sell their products and receive any profits. This type of inflation is caused cost-push inflation. Firms usually have to pay costs when either producing goods and services or selling them. For example, taxes or simply the cost of resources to produce them such as wood or oil. The firms will then see that their profits are affected and will raise their prices in order to receive more profit.

Imported inflation

If one countries prices are too high and you want to import goods from that country, you will have to pay a higher cost for them. This means that firms importing from those countries will be forced to raise their prices if they want to receive profit. This type of inflation is called imported inflation. This also shows that when one country is suffering from high inflation, other neighbouring countries will also see some consequences due to this problem.

Costs of inflation

Governments and central banks like the ECB aim to keep inflaton at around 2%. This low and stable inflation is good because money will not lose its value rapidly. A low inflation rate also means that interest rates are low, which makes it better for borrowing money. People and firms will be more optimistic when making loans from banks. It also helps to keep wages always rising and make a decrease in wages a rare thing, which in general is good for the economy and for the individual workers. Low inflation will also make the country more competitive in terms of trading internationally as it might be good to buy resources to produce prodcuts from one country where inflation is low.
However, the problem with inflation in a more personal aspect is that it takes away the value of your money. Say you have one dollar today, if inflation was 5% per year, you would have 78 cents in 5 years from now and only 61 cents in 10 years in purchasing power. It is sometimes therefore not smart to put your money in a savings account where the interest rate offered is less than the inflation rate of your country because every year you will lose purchasing power.
Real income represents how much you can actually buy with your income. Even though your income might be higher every year, this is because of inflation, and again, like with saving, if the percentage increase in income from one year to the other is lower than the inflation that year, you will be losing real income, or purchasing power, meaning that actually you are now earning less in terms of what you can buy with that money.
People that are affected severely by this are pensioners. Pensioners are people who have retired and are now living off their possibly only source of money, their pension. This is usually a fixed annual or monthly payment, for example, 1,000 euros every year, and won't be adjusted or raised to meet inflation. If you are a pensioner, your money will be worth less and less as the years go by.
These are the costs of inflation in an economy:

It imposes additional costs on firms

When there is inflation, prices will rise and therefore, there will be more costs imposed on firms to produce their goods and services. Also, when the firms have to increase prices, they will have to relabel, make changes to their inventory and other hard tasks.

It reduces competitiveness of exports

If there is inflation, exports from that country will be less valuable than other countries with lower inflations because it will cost lest to import from cheaper countries that offer the same goods and services.

It creates economic uncertainty

If inflation is unsteady and cannot be properly predicted, firms and people will find it difficult to plan ahead on their savings, purchases or loans.

Deflation

Deflation occurs when inflation is negative. Prices tend to fall during deflation. This is because:

• The market supply has increased relative to demand
• Competition between firms to supply them has increased
• Labour productivity rises, increasing output and reducing average costs
• Technological advance has reduced costs of production
• Market demand for goods and services has fallen

Deflation should not be confused with disinflation, which is when inflation is slowed down and is less than average.

One of the ECB's roles is to maintain a steady 2% inflation rate