Day 64: Inflation - Part 1

What is this thing called inflation?

Inflation simply refers to the continuous increase of prices in an economy. So - two points are important to note: if prices go up and then remain stable for a while, we don't refer to it as inflation, as inflation only applies to a continuous increase in prices. Secondly - if the price of petrol keeps rising, but all other prices remain somewhat stable, we're also not dealing with inflation, because in the case of inflation all prices keep rising.

Measuring Inflation

One of the most common ways to measure inflation is by making use of the consumer price index (CPI). Remember from the previous blogs, that CPI reflects the cost of a representative basket of goods and services. To obtain the inflation rate, we calculate the percentage change int he CPI from one period to the next. Meaning - if the inflation rate is 7.5%, it means that the cost of purchasing a representative basket of goods and services increased by 7.5% from one year to the next.

Effects of Inflation

One of the major economic effects of inflation is that what a country is trying to sell to other countries, eg. exporting, will be more expensive for foreign countries to buy. Therefore, an economy loses its competitive edge on the international market and the performance of the economy generally goes down - in turn, affecting everyone operating within it. Another more obvious effect, of course, is that the cost of living increases, people become fearful and agitated and start throwing accusations around about who's to blame for the inflation. Some, however, claim that the greatest danger about inflation is that it will cause more inflation. When inflation occurs, people expect prices to keep on rising - therefore, they will quickly go and buy as much as they can now, before prices get even higher. Because more products are suddenly demanded, prices go up and thus, the inflation rate often increases, even pushing the economy in some cases towards 'hyperinflation'.

The Causes of Inflation

There are two main causes of inflation: demand-pull inflation and cost-push inflation.

Demand-pull inflation

The term speaks for itself - demand-pull inflation occurs when increased aggregate demand for goods and services pushes prices up. Aggregate demand can go up in any of the following cases, or combination of cases:
- when consumption spending increases
- when firms increase their investment spending
- when governments increase their spending
- when export earnings increase
In other words - whenever the amount of money in circulation increases in an economy, the prices will go up. Check: the more money is available in an economy, the less it is worth, which is reflected in higher prices - because with the same amount of money in your pocket, you can now purchase less stuff, which means that your money is not worth as much as it used to anymore.

Cost-push inflation

Cost-push inflation occurs whenever an increase in production costs is responsible for pushing up the price level. In other words:
- when wages and salaries increase
- when the cost of imported capital and imported goods increases
- when profit margins increase
- when productivity decreases
- when natural disasters occur, such as droughts or floods
In the case of cost-push inflation, we don't only have to deal with an increase in prices, but we also have to deal with a decrease in income and productivity. This is referred to as 'stagflation'.