What is inflation?

Views 21KAug 9, 2023

Key Takeaways

● Inflation refers to a general increase in the prices of goods and services over a givenperiod.

● Inflation rate = (Final CPI Index Value- lnitial CPI Value) / lnitial CPI Value*100%

● Inflation is usually classified into three types: Demand-Pull Inflation, Cost-PushInflation, and Built-In Inflation.

Understanding Inflation

In economics, inflation refers to a general increase in the prices of goods and services in an economy over a given period.

When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of the currency. This decline of purchasing power impacts the general cost of living for the common public.

It is universally recognized by economists that sustained inflation occurs when a nation's money supply growth outpaces its economic growth.

Inflation can be contrasted with deflation, which occurs when the purchasing power of the currency increases and prices decline.

Sharp deviations from a modest inflation rate in either direction may cause significant economic disruption. They also have varying and often unpredictable effects on different asset classes.

To address the negative impacts, a country's central bank takes necessary steps to manage the supply of money and credit to keep inflation within permissible limits and keep the economy running smoothly.

Measuring inflation

The inflation rate is used to measure the overall impact of price changes for different products and services and provides a single value representation in an economy over some time, most commonly a year.

While it is easy to measure the price changes of individual products over time, human needs extend beyond one or two such products. Individuals need a big and diversified set of products as well as a host of services for living a comfortable life.

Depending on the selected set of goods and services used, multiple types of baskets of goods and services are calculated and tracked as price indexes. The most commonly used price index is the Consumer Price Index (CPI) .

The CPI examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weights in the whole basket.

Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.

In the US, the Bureau of Labor Statistics reports the CPI every month since 1913.

Mathematically, Inflation rate = (Final CPI Value-Initial CPI Value) / Initial CPI Value*100%.

Three types of inflation

Inflation is usually classified into three types: Demand-Pull Inflation, Cost-Push Inflation, and Built-In Inflation.

Demand-pull effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy that exceeds the economy's production capacity. This increase in demand leads to price rises.

Cost-push effect

Cost-push inflation is a result of the increase in the prices of inputs in production. When additional supplies of money and credit are channeled into a commodity or other asset markets, coupled with a shortage of key commodities, costs for intermediate goods will rise.

This will lead to higher costs for the finished products or services and work their way into rising consumer prices.

Built-in inflation

Built-in inflation is related to adaptive expectations, the idea that people would expect the rising inflation to continue if it increased last year. As the prices of goods and services rise, workers and others come to expect that they will continue to rise in the future at a similar rate. So they will demand higher wages to maintain their living standards. The increased wages may result in a higher cost of goods and services, forming a vicious cycle.

Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.