What exactly is "Inflation"?
We’ve all seen the prices of everyday goods rise over the time we’ve been alive, and more so, in the past two years. The cost of everything is up, from everyday items like milk to big-ticket items like cars, and it has been the case since we all can remember.
So the phenomenon we just talked about is named “Inflation”. A rise in the prices of almost all goods means a reduction in the purchasing power of money, since $100 can’t buy what it would have 10 years back. Inflation is typically measured by calculating the average price increase for a basket of selected goods and services over a period of time. This basket includes things an everyday person needs to live, for example, commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like healthcare and entertainment. Let’s talk about why this happens.
Inflation is caused due to more money getting into circulation in the economy. This is generally done to stimulate/encourage spending in the economy. And it can be done by a number of methods. The government could simply print more and give it away to citizens. It could devalue the currency to increase exports. But the most common method the money supply increases is by the government buying bonds from banks, which means new money for the banks to lend out. The money lent by banks is now a part of the economy and it therefore increases the money supply in the economy.
Typically three types of inflation are possible:
Demand-Pull Inflation: When the money supply increases in the economy, demand for goods and services increases. And this in turn leads to the prices of goods rising due to supply being lesser than the new demand.
Cost-Push Inflation: When the new money created finds its way to commodity and asset markets, costs for these goods rise. This generally happens when there is a sudden decrease in or shock to the supply. Commodities in particular are needed as inputs to other products and the higher input prices are in turn passed down to consumers in the form of higher retail prices.
Built-in Inflation: Since it has been a part of our lives for as long as we remember, we expect it to happen in the future as well. So the workforce demands higher wages/salaries to maintain the standard of living with rising costs. So there is a bit of a circular effect, where price increases lead to wage increases which in turn leads to price increases and so on.
The Good and The Bad Sides of Inflation
People who hold sound assets generally are better off with inflation, since the new money in the system reaches the asset owners in one way or the other. For example, when you buy groceries for more than you bought last month, that extra money shows up in the income statement of the retail chain, which will make the company and its stock more attractive and therefore benefit the asset holders (the shareholders in this case).
On the other hand, people who want to buy real assets, like houses and stocks, during periods of high inflation, have to pay much higher prices. And, the prices paid could be higher than the real value of the house or the asset.
As we discussed before, inflation reduces the purchasing power of your money. In fact, since 1933, the U.S. dollar has lost 92 percent of its domestic purchasing power! People in the 1950s could have bought houses for maybe $10000 which would now cost more than $1 million.
Some economists believe that low, stable, planned-for/predictable inflation is actually good for the economy. Since it is predictable, wage and other contracts can be set more accurately and not be to the detriment of either party. If it is low, it does not eat too much into the purchasing power of money but still incentivizes consumers to purchase things sooner since they will be available only for a price higher later.
But, when the inflation is not controlled, you get situations like Zimbabwe or Argentina. The rates could get to 1000% or more per year and prices could multiply for everything on a daily basis. At one point, the money might not even be worth the paper it’s printed on! The term used for such out-of-control inflation is “Hyperinflation”.
“Deflation” on the other hand, means falling prices in the economy. And when prices are falling, people can delay purchases, for a better price in the future. This would lead to lesser economic activity and hence, lesser profits for producers in the country. This hurts the country’s growth. This situation has been playing out in Japan for the past 25 years.
We’ll talk about how governments can forcefully increase or decrease inflation rates in an economy some other time. But for now, that’s it for this article. Subscribe for free to receive new posts and support my work. And do let me know if you want a specific topic covered!
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