What Is Inflation?
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed a a percentage means that a unit of currency effectively buys less than it did in prior periods.
Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.
Causes of Inflation
An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, by legally devaluing (reducing the value of) the legal tender currency, more (most commonly) by loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market. In all such cases of money supply increase, the money loses its purchasing power.
Types of inflation
The inflation can be classified into three types:
- Demand-Pull inflation,
- Cost-Push inflation
- Built-In inflation
Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises.
Cost-Push Effect
Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodity, costs for all kind of intermediate goods rise. These developments lead to higher cost for the finished product or service and work their way into rising consumer prices. For instance, when the an expansion of the money supply creates a speculative boom in oil prices the cost of energy of all sorts of uses can rise and contribute rising consumer prices, which is reflected in various measures of inflation.
Built-In Inflation
Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs/wages to maintain their standard of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.
Types of Price Indexes
Most commonly used price indexes are the
- Consumer Price Index (CPI)
- The Wholesale Price Index (WPI).
- The Producer Price Index
The Consumer Price Index
The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. 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 or deflation.
The Wholesale Price Index
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level.
The Producer Price Index
The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.2
The Formula for Measuring Inflation
The above-mentioned variants of price indexes can be used to calculate the value of inflation between two particular months (or years). While a lot of ready-made inflation calculators are already available on various financial portal and websites, it is always better to be aware of the underlying methodology to ensure accuracy with a clear understanding of the calculations. Mathematically,
Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value)*100
Say you wish to know how the purchasing power of $10,000 changed between Sept. 1975 and Sept. 2018. One can find price index data on various portals in a tabular form.
Controlling Inflation
It is done by implementing measures through monetary policy, which refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.
Price stability—or a relatively constant level of inflation—allows businesses to plan for the future since they know what to expect. The Fed believes that this will promote maximum employment, which is determined by non-monetary factors that fluctuate over time and are therefore subject to change. For this reason, the Fed doesn't set a specific goal for maximum employment, and it is largely determined by employers' assessments. Maximum employment does not mean zero unemployment, as at any given time there is a certain level of volatility as people vacate and start new jobs.
What are the effects of inflation?
Inflation can affect the economy in several ways. For example, if inflation causes a nation’s currency to decline, this can benefit exporters by making their goods more affordable when priced in the currency of foreign nations. On the other hand, this could harm importers by making foreign-made goods more expensive. Higher inflation can also encourage spending, as consumers will aim to purchase goods quickly before their prices rise further. Savers, on the other hand, could see the real value of their savings erode, limiting their ability to spend or invest in the future.
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