Economic inflation is defined as a quantitative measure of the rate at which the average price level of a good of selected goods and services rises in the economy during a given period of time, which is often expressed as a percentage, and thus inflation indicates a decrease in the purchasing power of a country’s currency.
Inflation can be compared to deflation that occurs when prices fall instead.
As prices rise, one unit of currency loses its value as it buys fewer goods and services.
This loss in purchasing power affects the general cost of living for the general public which ultimately leads to slowing down of economic growth.
To combat this, the appropriate monetary authority in a country, such as a central bank, takes the necessary measures to keep inflation within permissible limits and to keep the economy running smoothly.
Inflation is measured in a number of ways depending on the types of goods and services considered and it is the inverse of deflation which refers to a general decline in the prices of goods and services when the inflation rate falls below 0%.
Rising prices are the cause of inflation, although this can be attributed to various factors.
In the context of causes, inflation is categorized into three types: demand-pull inflation, cost-push inflation, and internal inflation.
Demand-pull inflation (demand-driven inflation):
Demand-induced inflation occurs when the total demand for goods and services in the economy increases faster than the economy’s productive capacity, which creates a gap between production and demand, in other words, an increase in demand and a decrease in production occur, which leads to higher prices.
For example, when oil-producing countries decide to reduce oil production, this lower production of current demand leads to higher prices and contributes to inflation.
Cost-push inflation results from an increase in the prices of production process inputs.
Examples include an increase in labor costs to manufacture a good, provide a service, or increase the cost of raw materials.
These developments raise the cost of the final product or service and contribute to inflation.
Internal inflation is the third reason that is related to adaptive expectations.
As the prices of goods and services rise, workers expect and demand more costs (wages) to maintain their cost of living. Their increasing wages lead to a rise in the cost of goods and services, and this spiral of wage price continues as one factor pays the other and vice versa.
In theory, monetary theory establishes the relationship between inflation and the money supply of the economy.
For example, in the wake of the Spanish conquest of the Aztec and Inca empires, huge amounts of gold, especially silver, poured into the Spanish and other European economies.
Since the money supply increased rapidly, prices rose and the value of money decreased, which contributed to the economic collapse.
The country’s financial regulator has the responsibility to keep inflation under control.
This is done by implementing measures through monetary policy, which refer to the actions of the central bank or other committees that determine the size and rate of growth of the money supply.
In the United States, for example, the monetary policy objectives of the Federal Reserve include long-term moderate interest rates, price stability, and maximum employment opportunities, each of which aims to promote a stable financial environment.
It is clear that the Federal Reserve is shifting its long-term inflation targets in order to maintain a steady long-term inflation rate, which in turn maintains price stability.
Price stability or a relatively stable level of inflation allows companies to plan for the future because they know what to expect.
It also allows the Federal Reserve to encourage maximum employment, which is determined by non-monetary factors that fluctuate over time and are thus subject to change.
For this reason, the Federal Reserve does not set a specific target for maximum employment, and it is largely determined by member ratings.
Employment cap does not imply zero unemployment, as there is at any time a certain level of volatility as people leave and start new jobs.
Monetary authorities also take exceptional measures in harsh economic conditions.
For example, in the wake of the 2008 financial crisis, the US Federal Reserve kept interest rates near zero and continued a bond-buying program – now discontinued – called quantitative easing.
But inflation peaked in 2007 and declined steadily over the next eight years.
There are many complex reasons why QE did not cause inflation or hyperinflation, although the simplest explanation is that the recession itself was a very prominent deflationary environment, and that quantitative easing supported its effects.
Stocks are the best way to hedge against inflation, as rising equity prices include the effects of inflation.
Since any increase in the cost of raw materials, labor, transportation, and other aspects of the process leads to an increase in the price of the final product produced by the firm, the inflationary effect is reflected in stock prices.
Imagine your grandmother put a $ 10 bill in her old wallet in 1975 and then forgot it.
The cost of gasoline during that year was about $ 0.50 per gallon, which means she could then buy 20 gallons of gasoline for $ 10.
Twenty-five years later in 2000, gasoline cost about $ 1.60 per gallon.
If she found the forgotten paper in 2000 and then kept buying gasoline, it would have bought just 6.25 gallons.
Although the $ 10 bill remained the same in relation to its value, it lost its purchasing power by about 69% over a period of 25 years.
This simple example shows how money loses its value over time when prices rise.
This phenomenon is called inflation.
However, it is not necessary that prices always rise over time.
It may remain steady or even decrease. For example, the cost of wheat in the United States reached a record high of $ 11.05 a bushel during March 2008.
By August 2016, it was down to $ 3.99 a bushel which could be attributed to a variety of factors such as good weather conditions leading to increased wheat production.
This means that a given bill of currency, say $ 100, would have had less wheat in 2008 and more in 2016.
In this case, the purchasing power of the same $ 100 bill increased during the period in which the commodity’s price declined. This phenomenon is called deflation and is the opposite of inflation.