Inflation is defined as a sustained increase in the general level of prices for goods and services in a county, and is measured as an annual percentage change. Under conditions of inflation, the prices of things rise over time. Put differently, as inflation rises, every dollar you own buys a smaller percentage of a good or service. When prices rise, and alternatively when the value of money falls you have inflation.
The value of a dollar (or any unit of money) is expressed in terms of its purchasing power, which is the amount of real, tangible goods or actual services that money can buy at a moment in time. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar does not go as far as it did in the past. This why a pack of gum cost just $0.05 in the 1940’s – the price has risen, or from a different perspective, the value of the dollar has declined. In recent years, most developed countries have attempted to sustain an inflation rate of 2-3% by using monetary policy tools put to use by central banks. This general form of monetary policy is known as inflation targeting.
Causes of Inflation
There is no single theory for the cause of inflation that is universally agreed upon by economists and academics, but there are a few hypotheses that are commonly held.
Demand-Pull Inflation – Inflation is caused by the overall increase in demand for goods and services, which bids up their prices. This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in rapidly growing economies. This theory is often promoted by the Keynesian school of economics.
Cost-Push Inflation – Inflation is caused when companies' costs of production go up. When this happens, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of natural resources or imports.
Monetary Inflation – Inflation is caused by an oversupply of money in the economy. Just like any other commodity, the prices of things are determined by their supply and demand. If there is too much supply, the price of that thing goes down. If that thing is money, and too much supply of money makes its value go down, the result is that the prices of everything else priced in dollars must go up! This theory is often promoted by the “Monetarist” school of economics.
Costs of Inflation
Inflation affects different people in different ways, with some benefiting from its effects at the expense of some who lose out. It also depends on whether changes to the rate of inflation are anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the impact isn't necessarily as severe. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as prices go up.
Here is a brief account of the typical winners and losers from inflation:
- Creditors (lenders) lose and debtors (borrowers) gain under inflation. For example, suppose a bank issues you a 30-year mortgage to buy a house at a fixed interest rate of 5% per year, costing $1,000 per month. As inflation rises, the “cost” of that $1,000 per month decreases, which benefits the homeowner, especially if the rate of inflation exceeds the interest rate on the loan.
- Inflation hurts savers since a dollar saved will be worth less in the future. Unless the money is saved in an account that pays an interest rate at or above the rate of inflation, the purchasing power of savings will erode. This phenomenon is sometimes called "cash-drag."
- Workers with fixed salaries or contracts that do not adjust with inflation will be hurt as the buying power of their incomes stay the same relative to rising prices.
- Similarly, people living off a fixed-income, such as those below the poverty line, retirees or annuitants, see a decline in their purchasing power and, consequently, their standard of living.
- Landlords benefit, if they have a fixed mortgage (or no mortgage) as they are able to raise the rent more each year.
- Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
- The entire economy must absorb repricing costs (menu costs) as price lists, labels, menus and more have to be updated.
- If the domestic inflation rate is greater than that of other countries, domestic products become less competitive.
Variations on the Theme of Inflation
There are several variations on the theme of inflation.
Deflation is when the general level of prices are falling. It is the opposite effect of inflation. Deflation tends to occur more rarely and for shorter periods of time than inflation. Deflation occurs typically during times of recession or economic crisis and can lead to deep economic crises including depression. The reason for this is the so-called deflationary spiral: when prices are going down, why would you spend your money today, when each dollar will be more valuable tomorrow? And why spend tomorrow when each dollar can buy more the day after? The result is that people stop spending and hoard their money in anticipation of prices falling even further. If money is being hoarded, it isn’t being spent, so business profits collapse and people are laid off. Increasing unemployment leaves the economy with even less spending, and the spiral continues.
Disinflation is a condition where inflation is still positive, but the rate of inflation is decreasing – for example from +3% to +2%.
Hyperinflation is unusually rapid inflation, typically more than 50% in a single month. In extreme cases, this inflation gone awry can lead to the breakdown of a nation's monetary system or even its economy. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month! Likewise, in Zimbabwe, hyperinflation led to Z$100 trillion bills being printed that were worth only a few U.S. dollars. Hyperinflations have also famously occurred in Hungary and Argentina in the 20th century.
Stagflation is the rare combination of high unemployment and economic stagnation along with high rates of inflation. This happened in industrialized countries during the 1970s, when a rocky economy was confronted with OPEC raising oil prices resulting in a demand shock for oil. This sent the price of oil – and all of the products and services that use oil as an input – higher, even as the economy slackened.
People often complain when prices go up, but they often ignore the fact that wages should be rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages. A modest inflation is a sign that an economy is growing. In some situations, little inflation can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad – it depends on the overall economy as well as your personal situation.
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