Inflation

Macro · Oct 8, 2019

Inflation is a crucial concept in economics but the full meaning of inflation remains unclear for many people. We should always take inflation into account and manage it properly and it applies to any economic entity from a single household to a sovereign state.

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In this article, we’ll explain the main aspects of inflation to show how it works and how to manage it.

Table of Contents

What is inflation and How is it Calculated?

Inflation is a process that leads to a rise in the price of goods and services.

The most popular metric that gives us a hint about the magnitude of inflation is called Consumer Price Index (CPI). It’s measured by tracking annual changes in prices for a selected group (or “basket”) of goods and services. This basket contains all of the necessary goods and services used by an average consumer in order to satisfy all of his basic needs. Note that the content of this basket can vary, depending on the country in question because different countries and cultures may have different “basic” needs.

Here comes the first caveat with inflation measurement: it gives us a hint about the cost of living if an imaginary “average” person. Real people tend to have different needs and the effects of inflation are different for each real human being.

The collection of necessary goods and services used to measure inflation is determined by the statisticians’ opinions on basic human needs. Here is an example from statcan:

  • Food
  • Shelter
  • Household operations, furnishings, and equipment
  • Clothing and footwear
  • Transportation
  • Gasoline
  • Health and personal care
  • Recreation, education, and reading
  • Alcoholic beverages, tobacco products, and cannabis

Those items are weighed, which means that some items may take a bigger portion of the basket and other items might have a smaller share.

If the prices for those things would increase during the next year, that would mean that we’ll have to register yearly inflation of a certain magnitude. The governments tend to stick with inflationary policies so it’s uncommon for prices to fall but it’s also a possibility: a negative inflation is called deflation.

Is Inflation Good or Bad?

Generally speaking, low and predictable inflation of about 1-5% is considered to be a good thing for an economy, according to the majority of economists. Low but positive inflation is considered to be a sign of an active and healthy economy. If there is a rising demand for a broad range of goods and services, the supply side might need a bit more time to adjust, causing some minor natural inflation and this is usually fine.

Most of the central banks follow the so-called “Inflation targeting policy”. It means that the central bank commits to use all of its tools (interest rates, quantitative easing, etc.) in order to keep the inflation close to its target level. This target level is often set somewhere between 1-5%, which implies that low and predictable inflation is considered to be fine.

Deflation, the opposite process, can be quite dangerous because it might lead to stagnation and certain other problems within the economy. Some economists think that inflation doesn’t matter at all and the most important thing is consistency and predictability of future inflation or deflation. They argue that the real enemy of economic growth is uncertainty and we would be fine with any inflation or deflation as long as we can predict future price changes and adjust our plans accordingly.

➤ Read also: Negative Interest Rates

Although it’s still arguable that even a low level of inflation is ok, because it hurts people with low-interest savings and, frankly, everyone else. There is a question of who actually benefits from inflation and the only reasonable answer seems to be entities and individuals with lot of debt because inflation practically reduces their debt burden.

Inflation also distorts GDP metric and that is why there is a nominal GDP and a real GDP (this is the one that’s usually published). The latter metric shows the nominal GDP minus inflation, so, if the GDP (especially GDP per capita) growth is positive and relatively high (2 - 4%+), then the inflation might not be a big problem. This would mean that the economy is growing faster than inflation eats up the value of money (the purchasing power), ergo people must be getting richer, at least on average.

A country which has an inflation should also have the means of securing people’s savings from it. These can be bonds, deposits, and other easily accessible and safe investment products. If there is no way to get a rate of return on capital higher than the current inflation level, the affected people might move their capital abroad and invest it in the countries that can protect their wealth from inflation.

It can be said that a low inflation of 1-5% is not very harmful to the economy as long as there are ways for people to protect their capital from it, but a high inflation of 5-10% or more (hyperinflation), especially if it’s unpredictable, is a very damaging thing for any economy as it leads to an erosion of trust to the national currencies. Under hyperinflation, people can even switch to barter as it often happens in Venezuela.

How Inflation Damages Personal Savings

A high inflation has a negative impact on the whole economy, but an economy is a collection of business and individuals, thus the inflation hurts everybody. High inflation has a particularly bad impact on the middle class with some modest savings. Rich people usually know a way to invest their capital at a decent rate of return that covers the inflation, poor people don’t have much savings at all, so they have nothing to lose, but the middle class suffers from the inflation the most, because they often have some savings, but those savings are often not properly invested.

Basically, if a person has $10,000 on his savings account and the inflation rate was just 1%, as it’s in many developed countries, this person has lost $100 of his savings during that time. Technically speaking, savings weren’t lost, they are still there plus a tiny interest, but the value of money, ergo the purchasing power, is $100 (1%) less now.

For example, a $2095 basket of goods and services in Canada in 2014 cost just $100 in 1914, 100 years ago.

That is with a low rate of inflation of 3.09%. You can use this calculator provided by Bank Of Canada to see the harmful effect of inflation.

So, $1 today and $1 some years ago do not have the save value, and the reason for that is inflation. If the savings of an individual are not protected from the inflation with an interest that is higher than that, then he would practically lose them over time.

Salaries, wages, social benefits and even income of a business tend to rise each year according to the current inflation, but savings are not adjusted for it as the interest rates in banks are often very low and fixed, so it’s wise to look for a way to invest your money at a higher rate of return than a bank offers.

What is the Main Cause of Inflation?

There is a theory in economics (monetarism) that explains the cause of inflation with the following formula:

$$ \text{(M$\times$V) = (P$\times$Q)} $$

Where:

  • M: Quantity of money (money supply)
  • V: Velocity of money
  • P: Price of goods
  • Q: Quantity of goods

To understand this formula let’s imagine a small closed economy. For example, imagine an economy of just two households: 1st household with just 1 bill of $100 value (Benjamin) as its all possessions, and 2nd household without money, but with a few apple trees that produce 100 apples per year. The first household is buying all of those apples from the second one throughout a year for $100. At the end of each year, the first household receives another $100 from an unknown source outside.

So, we have got a rotation of money and goods in a small closed economy system:

$$ \text{(100$\times$1) = (1$\times$100)} $$

What would happen in this system if one of the variable changes? Let’s say that the 2nd household was able to increase its apples’ production by 10%, so now they are producing not 100, but 110 apples per year. How would it change the system?

Obviously, the equation became unbalanced now, something has to change:

  • Quantity of money may increase by 10%
  • The velocity of money may increase by 10% (this would mean more turnover of money during the year)
  • The price per apple may decrease by 10%

In our oversimplified example, we don’t have a proper turnover of money back and forth, thus the velocity of the money stays 1.

We’ll assume that the 1st household needs those additional 10 apples and wants to buy them, this would mean that the total size of the economy has grown, but the prices are still the same as they used to be $100 per 100 apples or $1 per 1 apple.

Also, the 1st household has only $100, they can’t pay the 2nd house $110 for 110 apples, but the 2nd household would probably decide to sell apples anyway because otherwise, they would just be rotting on the ground. Therefore, the 1st household would pay $100 for the 110 apples, and the economy is going to keep its rotation as it used to be. In this example, we are seeing 10% deflation as the price of an apple decreased from $1 to $0.9, and this is how the economy works, according to monetarism theory. To prevent the deflation, in this case, a regulator (central bank) would need to issue a new $10 bill and give it the 1st household to keep the economy and the prices the way they were, otherwise the old $1 would be always equal to $0.9 on the new reality.

Sure, this example is very simple and today’s economy is much more complex than that, but even here we can observe interesting processes. For instance, for the producer, the household 2, this new reality is not favorable, because they would make the same amount of money with an increased productivity, thus there is no incentive to increase efficiency. However, for household 2 the new reality is beneficial as they can get $110 value of goods for just $100.

If the situation was the opposite and the demand part of the economy, the household 1, somehow has gotten additional money (which was mostly the case in the real world history) that was not justified by increased production and supply, then we would see an inflation.

These days everything works in a more complicated way than it used to be many years ago, a lot of money in circulation is not physical anymore, it’s digital, thus there is no need to print most of it.

Central banks now just lend money to other banks at a certain rate (prime rate), and thus creating the money supply. To regulate the inflation they are adjusting their interest rate: if they want to make money cheaper and/or speed up the economy, they decrease the rate and lend a lot, if they want to make money more expensive and/or slow down the economy (and to fight the inflation), they would make the rate higher.

Keynesian economists have a different view on inflation and its causes, they mention 3 main causes of the inflation as follows:

  • Demand-pull inflation
  • Cost-push inflation
  • Built-in inflation

Demand-pull inflation is caused by increase in government and private spending, which leads to an increase in aggregate demand and investments. Basically, it means that some savings and investments are converted to spending and this creates additional demand, which leads to inflation.

An example might be a situation when a government decided to raise the wages of its employees. Those people would receive additional money and spend them within the economy (demand increased), but the supply is not increased yet, which would lead to an increase in prices.

Cost-push inflation is a general, sudden and unexpected decrease of the total supply in the economy, which leads to shortages and higher prices. This might happen due to many reasons, for example, a new tariff on foreign goods might cause it, or a natural disaster.

Built-in inflation is a natural process when workers demand higher wages and eventually make unions and force politicians to follow their demands. They justify their demands by raise of prices (inflation) and cost of living.

After they get higher wages, the total demand in the economy increases (as they are spending their new money on goods and services) and we are seeing the same effect as in the demand-pull inflation, that causes even more inflation. This process is always going naturally as a vicious circle.

There are more causes and theories on why inflation occurs, but it’s still an open subject because the modern economy became very complicated. A connection between inflation and unemployment is still arguable, but there are few examples here worth to mention.

One particularly interesting example would be to look at what happens when a country imposes tariffs, limits international trade or receives some sanctions. Imagine that a huge share of all goods in a country is imported, there is almost no local production. What would happen in a case when free movement of goods suddenly gets restricted by tariffs or something else? The demand of those goods stays the same, but the supply drops to zero. The only effect that can cause is an increase in prices of all the goods left in the country until this country figures out a way to start local production with at least the same quality as the importer used to provide. That is why it’s believed that the idea of free trade and Laissez-faire, in general, is superior to protectionism.

What is the Current Inflation and How to Find it?

Current inflation rates are published by central banks and other government or statistical agencies.

You can find the latest data on the current inflation on the world bank website, some data (a bit outdated) is available on the CIA World Factbook and various other websites like tradingeconomics.com are offering quite recent numbers, but those sources are less reliable.

It’s always an open question on how to find out the most recent and trusted statistics on inflation. Some countries and their statistical agencies (mostly in Europe and North America) are offering open and up-to-date data, yet the statistics on the inflation in certain other countries is sometimes questionable as those governments occasionally are “playing with numbers” to make it look like the overall situation is better than it actually is.

In addition to that different governments use different methods in their inflation calculations, so by one standard the official inflation rate might be equal to 3%, but another independent source might find it to be, say, 6%. Here is an explanation by The Economist on why the real inflation rate can be hard to calculate.

Conclusion

Inflation is a complicated subject that is hard to fully explain in just one article.

However, here are a few takeaways that we would like to stress about the inflation:

  • A low inflation of 1-5% is not necessarily a bad thing
  • Deflation can be even worse than inflation
  • Inflation could be beneficial for those in heavy debt
  • Inflation is managed by central banks
  • There are many different causes of inflation
  • Inflation damages middle class the most
  • It’s crucial to invest your savings at a higher than the inflation rate
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