What is inflation? Its causes and effects

Inflation is the rate at which general market prices rise. It is the opposite of deflation.

When inflation increases, each unit of currency buys a smaller percentage of a product (reflecting a drop in purchasing power parity).

For example, assume that a loaf of bread costs $2.50. However, the economy suddenly suffers from severe inflation causing that same loaf of bread to cost $3.00 – people now are getting less bread for their dollars.

One of the main indicators of inflation is the consumer price index (CPI) – which measures the change in prices over time. The CPI tracks the price of certain goods –  when the CPI goes up it means there is inflation.

Inflation plays an important role in economics, as it influences mortgage rates, the rates on savings accounts, personal income, and disposable income (how much of your pay is left over after paying for your living expenses).

How is inflation measured?

Economists used the CPI as the main component for measuring inflation. With this index, we know how much prices have gone up by over a specified period.

The Bureau of Labor Statistics defines CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

If a country’s CPI is 4 percent, it means that the average price of goods bought in the country is 4 percent higher than the year before.

Other indexes that are commonly used include: retail prices index (RPI), producer price indices (PPIs), commodity price indices, core price indices, GDP deflator, and asset price inflation.

When calculating inflation, some goods are weighted. This means that some products or services are given more importance, depending on the amount spent on them.

When the price of gas (UK: petrol) goes up, its impact on the inflation rate is considerably greater than if, say the price of duct tape rises. This is because a country’s population spends a greater proportion of its income on gas than on duct tape.

What causes inflation?

The most widely accepted theory of why inflation rises or declines is called “the quantity theory of money”.

The theory says that an economy’s money supply has a direct relationship with the price level of goods and services. This means that if there is more money in circulation then the price of goods will go up proportionally.

Short term inflation is thought to be influenced by the flexibility of prices, interest rates, and wages.

The lasting effects of short term inflation differ among various economic schools of thought.

The monetarist view is that prices and wages adjust quickly enough not to matter too much, while Keynesian economists believe that they adjust at different rates that can have a long-term impact.

History of inflation

The increase in the total amount of money or money supply has occurred many times throughout history.

Centuries ago, when gold was used as a currency, governments would collect gold coins and melt them down and mix them with others precious metals and then reissue them at the same nominal value as before.

Through diluting gold governments were able to issue more coins without the need to use more gold.

By reducing the cost of producing each coin governments would see an increase in the difference between the value of money and the cost to produce and distribute it.

As a result the money supply would increase and the value of each coin would drop. With the relative value of a gold coin dropping consumers would need to have more coins to purchase the same product as they would have before.

History has shown that infusions of gold or silver into the economy can cause inflation. This is easy-to-understand given the fact that as you add more currency into the economy the value of each unit becomes lower than what it used to be before because the money supply has increased.

The negative effects of inflation

The negative effects of inflation include:

  • Higher interest rates – discouraging business from borrowing.
  • Lower exports.
  • Less savings.
  • Mal-investments.

The positive effects of inflation

The positive effects of inflation include:

  • Businesses generating more profit and revenue.
  • Tax revenues increase.
  • Reduces the real value of outstanding debts.
  • Allows financial markets to function properly by shifting investment opportunities.

Inflation should not always be viewed as a bad. In fact, inflation can sometimes indicate the economy is growing, while a lack of inflation can often be a sign of an economy in decline.