All You Need to Know About Inflation: Reasons, Types, Impact on the Economy

Inflation is a term that is often thrown around in economic discussions, but it’s essential to understand what it means and how it affects the economy.

There are different types of inflation, such as demand-pull inflation, cost-push inflation, and hyperinflation, each with its unique causes and effects. Understanding the impact of inflation on the economy is crucial, as it affects various aspects, including employment, investment, interest rates, and consumer behavior.

In this guide, we will explore everything you need to know about inflation, including its reasons, types, and impact on the economy.

What Is Inflation?

Inflation is a general increase in the prices of goods and services over a period of time. It means that the purchasing power of money decreases, and each unit of currency can buy fewer goods and services than before. Inflation is typically measured using the Consumer Price Index (CPI), which tracks the prices of a basket of goods and services commonly purchased by households.

Inflation can be caused by various factors, including increases in the supply of money, changes in the demand for goods and services, and supply shocks that affect the availability and cost of production inputs.

Inflation is often expressed as an annual percentage rate, with higher inflation rates indicating a faster increase in prices. Moderate inflation is generally considered beneficial for the economy, as it encourages spending and investment. However, high or unpredictable inflation can have negative consequences, including reduced purchasing power, lower economic growth, and increased uncertainty.

Understanding Inflation

Inflation measures the general increase in prices of a diversified set of products and services that individuals need for a comfortable life. It impacts the cost of living and can lead to a deceleration in economic growth when the purchasing power of money decreases.

Economists believe that sustained inflation occurs when money supply growth outpaces economic growth. To keep inflation within permissible limits, the monetary authority, often the central bank, takes necessary steps to manage the money supply and credit. Inflation can be measured using the Consumer Price Index (CPI), which assesses the cost of living and how it changes over time.

The CPI formula takes the value of the market basket from a particular year, divides it by the value of the market basket from the base year, and multiplies that by 100 to produce a percentage. The inflation rate formula involves two key variables, the CPI starting cost and the CPI ending cost, which help calculate the percentage change and rate of inflation.

Reasons for Inflation

The following are some of the main reasons for inflation, and they can occur individually or in combination with one another:

1. Increase in demand. When the demand for goods and services exceeds the available supply, prices tend to rise, leading to inflation.
2. Increase in production costs. An increase in production costs, such as wages or raw material costs, can lead to an increase in prices, causing inflation.
3. Increase in the money supply. When there is an excessive increase in the money supply in the economy, people tend to have more money to spend, leading to an increase in demand and prices, which can result in inflation.
4. Decrease in taxes. A decrease in taxes can increase disposable income, leading to higher demand and prices, which can cause inflation.
5. External factors. External factors, such as an increase in oil prices or natural disasters, can lead to a decrease in the supply of goods and services, resulting in an increase in prices, and leading to inflation.
6. Exchange rate. A weak exchange rate can cause imported goods to become more expensive, leading to an increase in prices, and causing inflation.

Types of Inflation

Economists categorize the root causes of high inflation into two main categories, namely demand-pull inflation and cost-push inflation. The former occurs when the overall demand for goods and services increases more rapidly than the economy’s production capacity, often due to an increase in the supply of money and credit.

On the other hand, cost-push inflation happens when the prices of goods and services are pushed up due to an increase in the production costs, such as the cost of labor or raw materials. Meanwhile, there is also built-in inflation, which is caused by adaptive expectations, where people expect that the current inflation rate will continue in the future. Let’s explain broadly these types of inflation.

Demand-Pull Inflation

Demand-pull inflation occurs when the aggregate demand in an economy exceeds the aggregate supply. This increase in demand may happen due to an increase in money supply or income or the level of public expenditure.

Basically, demand-pull inflation refers to a situation where the supply of money and credit increases, leading to an overall increase in demand for goods and services that surpasses the economy’s production capacity. Consequently, the increased demand results in rising prices.

With an increase in disposable income, people tend to have a positive consumer sentiment, which leads to higher spending. This surge in spending leads to higher demand for goods and services, creating a demand-supply gap, which results in higher prices. Furthermore, if the supply of goods and services is not flexible enough to meet the increasing demand, it further pushes up the prices.

Cost-Push Inflation

This type of inflation occurs when the aggregate supply falls due to exogenous causes, leading to an increase in the price level. The aggregate demand remains unchanged in this case.

It occurs when the increase in prices is driven by rising costs in the production process. This happens when an increase in the supply of money and credit is directed towards commodity or asset markets, causing intermediate goods’ costs to rise. This effect becomes more pronounced during an economic downturn that negatively impacts the supply of essential commodities.

Ultimately, these rising costs get passed on to consumers through the prices of finished goods and services. For instance, if the money supply increases, it can create a speculative oil price bubble that raises the cost of energy and other products, contributing to inflationary pressures.

Built-In inflation

This is closely tied to the concept of adaptive expectations, which refers to people’s expectation that current inflation rates will persist in the future. When the prices of goods and services increase, people may anticipate a similar or higher rate of inflation in the future. Consequently, workers may demand higher wages to maintain their living standards. The resulting increase in labor costs raises the cost of goods and services, leading to a wage-price spiral. This spiral continues as each factor reinforces the other in a feedback loop, ultimately resulting in higher inflation.

Other types of inflation include the following:

• True inflation;
• Semi-inflation;
• Hyper-inflation;
• Creeping and moderate inflation;
• Repressed inflation.

How Inflation Affects Economy

Inflation can have both positive and negative effects on the economy, depending on its level and cause. Here are some ways in which inflation can affect the economy:

1. Reduced purchasing power. As prices increase, the purchasing power of money decreases. This means that consumers can buy fewer goods and services for the same amount of money, which can lead to a decline in consumer confidence and spending.
2. Uncertainty. High or unpredictable inflation can create uncertainty in the economy, making it difficult for businesses to plan for the future. This can lead to reduced investment and lower economic growth.
3. Reduced real wages. Inflation can reduce the real value of wages, even if nominal wages are increasing. This can lead to a decline in living standards for workers.
4. Increased interest rates. Central banks may raise interest rates to combat inflation, which can increase the cost of borrowing for consumers and businesses. This can lead to reduced investment and slower economic growth.
5. Increased exports. Inflation can make exports more competitive by lowering the relative cost of domestically produced goods. This can lead to increased exports and a boost to the economy.
6. Increased government revenue. Inflation can increase government revenue if taxes are linked to inflation or if inflation pushes individuals into higher tax brackets.

Hedging Against Inflation

Hedging against inflation can be done through various methods such as investing in inflation-indexed securities, real estate, commodities, precious metals, and dividend-paying stocks. You can also consider adjusting their investment portfolio to include assets that tend to perform well during inflationary periods, such as commodities, infrastructure, and stocks of companies with pricing power. Another approach is to invest in foreign currencies, particularly those of countries with low inflation rates. Additionally, individuals can also consider reducing debt, increasing their income, and adjusting their spending habits to combat the effects of inflation.

Bottom Line

As said earlier, inflation refers to a sustained increase in the general price level of goods and services over time. It can be caused by various factors, such as an increase in the money supply, supply chain disruptions, changes in demand, or cost-push factors. Inflation can have several negative impacts on an economy, including reduced purchasing power, decreased investment, and higher interest rates. It can also create uncertainty and instability, making it challenging for businesses and individuals to plan for the future. To hedge against inflation, individuals and businesses can invest in assets that are likely to maintain their value over time, such as real estate, stocks, and commodities.