Inflation – Definition

Cite this article as:"Inflation – Definition," in The Business Professor, updated October 4, 2019, last accessed October 25, 2020, https://thebusinessprofessor.com/lesson/inflation-definition/.

Back to: ECONOMIC ANALYSIS & MONETARY POLICY

Inflation Definition

Inflation is a measure of the degree at which the median price level of a set of goods and services and other commodities increase over a period of time or a designated duration. A basic definition of this concept is that it is the constants increase in the prices of goods and services, in which a currency unit gets to purchase less than what it used to before the occurrence of inflation. Inflation is generally given in percentage and it implies a loss or a reduction in the purchasing power of the currency of a country.

A Little More on What is Inflation

Inflation which occurs due to increase in prices of goods and services results in lower power of each currency unit of a nation. As price rises, a unit of currency will likely be unable to purchase what it used to buy before. Simply put, if the cost of a fan was $100 two years and it later increased to $120 in six months, a $100 bill which would have been able to purchase a fan two years ago will be insufficient for buying that same fan after a period of six months. The loss of purchasing power due to inflation generally affects the standard of living of the masses and subsequently leads to a decrease in the economic growth of the affected nation. According to a large number of economists, persistent inflation occurs due to an increase in a nation’s money supply without an increase in economic growth. In other words, when a nation’s money supply gets large to the extent that it cannot control the economic growth, inflation is bound to happen. To prevent such cases, the central bank of affected nations, or any other monetary authority would be required to implement different measures and regulations designed to keep inflation within permissible limits and sustain the nation’s economy. The measurement of inflation can be carried out by different tools and these measurements are dependent on the types of goods and services considered. Inflation is the opposite of deflation which generally occurs when there is a major decline in the prices of goods and services resulting from a decline in the inflation rate, especially when it goes under 0%.

Important Details

  • Inflation refers to the degree at which the total or average level of prices of commodities is rising and subsequently, the degree at which the purchasing power of a unit of currency is decreasing.
  • There are three main types of inflation: Demand-Pull inflation, Cost-push inflation, and Built-in inflation.
  • Inflation can be measured via different indexes and the most used index in the United States are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
  • Inflation can be both negative and positive depending on the people’s view. For individual with liquid cash in hand or cash stored in the bank, inflation is generally negative as it reduces the value of their money. On the other hand, for individuals with tangible assets and securities, inflation can be positive as it helps them acquire more gains if the increase in prices affects their assets.
  • Inflation is required in a country, however to an optimum level. This is because inflation helps to promote spending rather than savings, and this helps to bolster economic growth and development.

Illustration of Inflation

To better understand the effect of inflation, we’ll take a look at an imaginary yet relatable instance. Imagine you kept a $100 bill in one of your traveling bags in the year 2002 when you left the nation. Now after 10 years, you happened to return back to the country (i.e. in 2012) and you noticed that $100 bill among your luggage. Now, let us assume that a bag of corn in 2002 was sold at $2 per bag, and in 2012, it increased to $4 per bag. If you’d visited the market with that $100 bill in 2002, you would have gotten 50 bags of corn. However, since the price of corn has doubled through a period of ten years, you can only purchase 25 bags using your $100 in 2012. Here, the $100 bill remained the same as it didn’t undergo any changes. However, inflation occurred and this affected the purchasing power of your $100 bill though the years. Here, we can see that physical money tends to lose its value over time due to price increases. This is what is called inflation.

We stated earlier on that inflation can be positive and negative to individuals, and we suggested that persons with tangible assets tend to benefit more and persons with cash tend to lose more. This is not always the case. The cost of wheat in March 2008 hit an all time high of $11.05 per bushel, and in August 2016, it fell down to $3.99 per bushel. This decline in price was due to a number of reasons like excessively good weather conditions which enhanced wheat production during the period of eight years. In a situation like this, taking out your $100 to a wheat farm in August 2016 would give you 25 bags of wheats, but it would have given you just 9 bags in March 2008. Here, the purchasing power of your currency unit increased while inflation rate fell below zero percent. This is called deflation which occurs when inflation is not in play and the prices of goods are not stagnant.

Measuring and computing the changes in price of unit commodities can be a small feat as there are different tools to acquire this. It basically doesn’t take more than a simple mathematical simplification. However, since human needs and wants expand over time due to desires and needs for survival, one needs to think of inflation in terms of the general economy and not just limited to a single or a set of products. Inflation in finance tends to compute all the different aspects of the price levels in an economy even going as far as measuring wages, and labor. The result is usually depicted as a single value representation in the form of percentage and used to cover the total and general increase of price levels across all sectors.

Inflation: The Causes

Inflation is typically caused by a constant rise in the prices of goods and services, and this steady increase can be attributed to a number of factors. We earlier stated the three types of inflation: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation, and we’ll take a better look at each of them in the upcoming session.

Demand Pull Inflation

Demand-Pull inflation tends to occur when the demand for a particular commodity or set of commodities is higher than the market supply. In a situation like this, the economic production capacity would be unable to handle the increasing demand and this would make them opt for a price increase. This is more like the basic supply-and-demand theory where higher demand leads to higher price and higher supply after prices increases. A typical example of this type of inflation was in the case of the oil producing nations in the world when they decided to cut back on international supply. This led to an incessant increase in demand and these nations had to increase the prices to gain more on the barrels being sold. Also, when the amount of money supply in a nation increases, inflation also tends to increase. When individuals acquire more wealth, a positive thinking, though not always rational, would be impulse spending and higher release of money on expensive products. This will unfortunately lead to higher demand and consequently higher prices than what that product would’ve been sold for. A typical example of such a case would be buying limited editions of cars from manufacturers. Money supply is generally increased by monetary authorities and agencies in a nation and it is done either by printing a larger amount of money and distributing them to individuals, or by reducing the value of the national currency. All cases of high demand typically ends in a loss of purchasing power of any currency unit in affected nations. Monetarism has its fair share in inflation as is the link between inflation and money supply of a country’s economy. Looking back at history, after the Spaniards conquered the Aztec and Inca empires, a huge and enormous sum of gold and silver sterlings started to flow head on into the Spanish economy as well as other European economies. Due to this uncontrollable money supply, the prices of goods and services increased substantially and this led to the collapse of the Spanish economy.

Cost-Push Inflation

Cost-push inflation usually generates from production processes. It occurs when there is an increase in the factors and cost of production. Examples include: when workers demand higher wages to manufacture products, when raw materials cost more, and when distribution costs more or becomes more riskier. These new developments generally lead to higher cost of manufactured products and services, thus giving to inflation.

Built-In Inflation

This type of inflation is generally affects all sectors and persons in the economy and it is basically caused by no-one. Built-In inflation occurs when the prices of commodities in a nation are increasing and then labor demands higher wages to keep up with or maintain their standards of living due to the higher costs of finished products. It is generally likened to a cycle of increased spending, and it continues infinitely.

Different Inflation Index

The two main inflation indexes used in computing the general increase in price levels in a national economy include: the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). Each index works in different ways depending on specific goods and services used.

The Consumer Price Index (CPI) is a computing index which analyses the weighted average of the prices or costs of a range of selected commodities which satisfy the primary consumer needs or the end user. Consumer Price Index (CPI) is measured by collecting the changes in price of each item in the selected range and averaging them based on their relative weight to all the products in the whole selected range. The prices that are generally considered are the retail cost of each commodity that is available to each consumer in the nation. CPI changes are used to determine the price changes associated with the standard of living, and since it is aimed at the masses, it is usually the most used index for computing inflation and deflation in the nation. CPI is mainly reported on a monthly basis by the U.S. Bureau of Labor Statistics and this reports can be dated as far back as 1913 when it was first implemented.

The Wholesale Price Index is the second type of measurement index used to measure inflations and deflation in the nation. This index measures and computes the changes in the price and costs of commodities at the wholesale level. While the Consumer Price Index is focused on the buyers and retailers, the Wholesale Price Index is focused on the seller, the wholesaler and sometimes the manufacturer. WPI mostly computes the costs of wholesale products such as cotton yarns, cotton gray goods, cotton fabrics and raw cottons among others. While most countries make use of the Wholesale Price Index (WPI), a large number of nations prefer to stick to the Producer Price Index (PPI), which is a variant of the WPI.

The Producer Price Index is a group of inflation and deflation indexes that are used in computing the median changes in the general price level received by domestic producers of commodities over a designated period of time. The Producer Price Index measures the price changes from the viewpoint of the seller just like the Wholesale Price Index, and unlike the Consumer Price Index.

In all measuring indexes, the possibility that the price of one product in a selected range will cover up the price of another product in the same range is high. A typical example would be the possibility of the price of cotton cancelling out the cost of wheat or corn to a certain degree. Each variant basically represents the average weighted cost of inflation for the given constituents which may be applied at the general economy or commodity level.

Measuring Inflation Using Inflation Index: Mathematical Computation

Both the Wholesale Price Index, the Consumer Price Index, and the Producer Price Index can be utilized in computing the value of the inflation between two successive months or years. While there are a lot of ready-made inflation calculators on different financial portals and websites, a basic example of how to calculate inflation index won’t hurt. Here is the mathematical formula for calculating inflation increase:

Rise in Inflation = (Final Consumer Price Index Value / Initial Consumer Price Index Value)

For instance, let us assume that you wish to have a knowledge of how the purchasing power of $10,000 changed from September 1975 to September 2018. It is easy to get this data from a portal like inflationdata.com. Using the data from this table, you can pick up the Consumer Price Index values for the two different years. According to the table, the value for September 1975 was 54.6, and that of September 2018 was 252.439. Here, 54.6 becomes our initial value and 252.439 becomes our final value.

Using our mathematical formula, we will get:

Rise in Inflation = (252.439 / 54.6) = 4.6234 = 462.34%

In order to get the value of the purchasing power of a September 1970 $10,000 in September 2018, you simply have to multiply the rise in inflation factor with the amount to get a dollar value:

Dollar Value Change: 4.6234 x $10,000 = 46,234.25. To get the final dollar value of the end period, sum the original dollar amount with the dollar value change. This is denoted as:

Final Dollar Value: $10,000 + $46,234.25 = $56,234.25.

This implies that the worth of a September 1975 $10,000 is equivalently to the value of a September 2018 $56,234.25. Thus, if you were able to buy any product with $10,000 at that time, it would require you spend $56,234.25 for those same products in 2018, assuming all other factors remain constant.

Effects of Inflation

Inflation can benefit some people while it also can have a negative effect on others. It all depends on the position of one’s monetary amount at the point of price increase. For instance, if the cost of housing previously sold for $30,000 turned out to be worth $400,000 in the future, it would be a good news for the seller of such a property or the owner of such a property. However, the buyer won’t be as happy as the seller as he has to pay more for a property. In a case like this, the seller would benefit from inflationary prices of housing, while the buyer would suffer the negative effect of such increase in prices.

Persons in possession of physical cash would also feel the negative effect of inflation. This is because the purchasing power of their currency unit would drop considerably, and when this occurs, they won’t get to buy as much as they once did with the same currency value. Inflation also benefits business projects as well as individuals holding company stocks, as they get to except better returns in the near future.

Despite the positive and negative effects of inflation in a nation, it is always needed, at least at an optimum level to bolster economic growth. If the purchasing power of a currency remains the same through the years, spending and saving would remain constant, and in most cases, savings would surpass public spending as people can decide to limit the purchase of goods and products which will turn affect the economic development. The best way to bolster the nation’s growth in this case is to leave inflation value in an optimum and controllable range.

Over-inflation, deflation, and inflationary uncertainty can impact a nation’s economy negatively. All three forms of inflations can lead to unpredictability in the market and consequently prevent businesses from making investment decisions. If it occurs, there will be an increase in unemployment as well as excessive hoarding of stocks by individuals. It can also lead to incessant demand for goods and services, as people will look to store products which they’ll need in the future due to fear of price rising in the positive direction. Uncertainties can also lead to fluttering international trades as well as impact foreign exchange rates.

Controlling Inflation

Inflation is generally maintained or controlled in a nation but its financial regulators or related authorities. Different inflationary measures via monetary policies are enacted within the community,  and these policies basically refer to actions implemented by central banks and other financial committees that help in determining the rate and size of the growth or increase in money supply in the country. The United States is one of those countries that makes use of authorities in controlling inflation. The U.S. Feds monetary policy goals comprise of the moderation of interest rates in the long-run, maximum employment and minimum unemployment, and price stability, and it intends that each of its set goal would be able to promote and increase the financial environment of the nation. The U.S. Federal Reserves generally communicates inflation targets in the long run with the aim of keeping tabs on a constant but stead interest rate in the future consequently resulting in price stability. This price stability assists businesses and firms in planning for the future as well as making valid investments since they generally have an idea of the potential strength of coming inflations. Price stability also assists the Federal Reserves in promoting maximum employment.

Maximum employment in this case doesn’t refer to a situation where almost all the individuals in a nation are employed. This is due to volatility as people tend to change job positions thus leaving the previous ones vacant or occupied by someone who just left a position vacant. It is like a continuous cycle.

When the economy of a nation is hitting extreme levels, monetary authorities are expected to take different measures to plunge the economy out of recession or financial crisis. An example would be case of the 2008 financial crisis, where the U.S. Federal Reserves maintained interest rates close to 0%, an action popularly known as quantitative easing. While there was different statements and views that this action would increase inflation, the reverse became the case as inflation decreased over the next eight years. The reasons why quantitative easing didn’t lead to inflation and hyperinflation are numerous, and the strongest claim was that recession tends to lead to deflation, and the quantitative easing backed up this action.

 

Following this crisis and the effects of the QE, U.S. policy makers have suggested keeping inflationary increase at 2% per year. The European Bank has also engaged in steady management of inflation, this time using a more aggressive form of quantitative easing. This action has led mostly to negative interest rates as most people and businesses are afraid that the euro zone could fall into deflation pretty soon, thus resulting in economic stagnancy. However, nations with higher rates of economic growths tend to contain and fare better with higher inflation rate. For instance, India aims for around 4% inflation increase per year, while Brazil’s target is around 4.5%.

Inflation Examples: Extreme Cases

Most currencies in the world are backed by commodities, thus an increase or decrease in the supply of these commodities can lead to inflation or deflation. Plus, since most currencies are fiat currencies, political aftermaths can impact money and lead an economy onto the path of inflation. An example of such a case is the German Weimar Republic’s hyperinflation which occurred in the 1920s. A couple of nations which have encountered damages due to Germany’s participation in World War I requested for reparations, and this consolidations could not be accepted in German currencies, as it was of suspect value due to the government’s incessant borrowing. To cover up the reparation cost, Germany attempted to print paper notes as well as buy foreign currency with these paper notes so as to cover up their debts. However, this policy led to hyperinflation since they was an enormous money supply in a declining economy. This action subsequently led to the German mark, and led to overspending on the part of German citizens due to fears of declining purchasing power of each currency unit in the future. As more money was needed to buy foreign currencies to pay off their debts totally, incessant money supply became the order of the day and this made almost all bills in the nation useless, till the point that people were using them for wall decorations. This same case was what occurred in Peru during 1990, and in Zimbabwe from 2007-2008.

Inflation: Trading and Safeguarding Against It

Stocks trading are considered as one of the best investments one could trade during a season of inflation or hyperinflation, as a rise in stocks prices are include of the aftermath of inflation. Stocks are viable materials against inflation since increases in the prices of raw materials and other production factors also leads to incremental stock values. Also, special financial instruments exist which one can make use of in safeguarding against inflation. Examples of such investment tools include: Treasury Inflation Protected Securities (TIPS), which is a low-risk treasury investment which moves along with the value of an economic inflation. One can also opt for a TIPS mutually traded fund or an exchange traded fund.

Opening a brokerage account is the best way to secure oneself from inflation via the use of stocks, bonds, and mutual funds as well as ETFs. While choosing a stockbroker can be quite a hassle, there are different resources out there that can help you make the perfect choice. You can simply perform an internet search for regulated and accredited brokerage firms, and also make sure to read reviews concerning these firms from previous or existing users.

References for “Inflation”

https://en.wikipedia.org/wiki/Inflation

https://www.investopedia.com/terms/i/inflation.asp

https://www.thebalance.com › Investing › US Economy › Inflation

https://www.moneycrashers.com/what-is-inflation-definition-causes-inflation-rate/

https://www.economicshelp.org/macroeconomics/inflation/definition/

 

Was this article helpful?