Inflation is the measurement of how much more costly a collection of goods and services has gotten over time, generally a year. It’s possible that it’s one of the most well-known economic terms. Inflation has thrown countries into a state of insecurity for extended periods of time. Many central bankers aim to be dubbed ‘inflation hawks.’ Politicians have won elections by promising to fight inflation only to lose power when they fail to do so. In 1974, President Gerald Ford designated inflation to be the No. 1 Public Enemy in the United States. So, what exactly is inflation, and why is it so critical?
Measuring Inflation
Inflation is the rate at which prices rise over time. Inflation is usually defined as an increase in the total price level or the cost of living in a country. It can, however, be computed more precisely for some items, such as food, or services, such as a haircut. Inflation, in any context, refers to how much more costly a particular set of goods and services has gotten over a given time period, most often a year.
The cost of living for consumers is determined by the pricing of a variety of goods and services, as well as their proportion in the household budget.
Government agencies undertake home surveys to identify a basket of frequently purchased commodities and track the cost of purchasing this basket over time in order to determine the typical consumer’s cost of living. (The largest component of the consumer basket in the United States is housing expenses, which include rent and mortgages.) The consumer price index (CPI) is the cost of this basket at a particular moment stated as a percentage change from a base year, and consumer price inflation is the percentage change in the CPI over a given period. (Inflation is 10% over the period of the base year CPI is 100 and the current CPI is 110.)
By removing prices set by the government and the more volatile prices of things such as food and energy, which are primarily affected by seasonal variables or temporary supply conditions, core consumer inflation focuses on the underlying and persistent trends in inflation. Policymakers also keep a careful eye on core inflation. An index with greater coverage, such as the GDP deflator, is required to calculate an overall inflation rate—for a country, for example, rather than just for consumers.
The CPI basket is typically kept constant throughout time for consistency, but it is occasionally changed to reflect changing consumption patterns, such as to add new hi-tech goods or replace ones that are no longer extensively purchased. The GDP deflator’s contents change each year and are more current than the mostly set CPI basket since it indicates how prices move on average over time for everything produced in an economy. The deflator, on the other hand, includes non-consumer items (such as military spending) and so isn’t a suitable indicator of living costs.
The good and the bad
Households are worse off if their nominal income, which they receive in current money, does not rise at the same rate as prices because they can afford to buy fewer things. To put it another way, their purchasing power or real (inflation-adjusted) income decreases. The standard of living is measured by real income. When actual incomes rise, the standard of living rises with them, and vice versa.
In actuality, prices fluctuate at various rates. Some, such as the prices of traded commodities, fluctuate on a daily basis; others, such as contract-based pay, require longer to adjust. In an inflationary environment, unevenly growing prices lower some customers’ purchasing power, and this erosion of real income is the single most significant cost of inflation.
Inflation can also affect the purchasing power of fixed-interest rate receivers and payers over time. Take, for example, retirees who are guaranteed a 5% annual rise in their pension. When inflation exceeds 5%, a retiree’s purchasing power decreases. A borrower paying a 5% fixed-rate mortgage, on the other hand, would gain from 5% inflation because the real interest rate (nominal rate minus inflation rate) would be zero; servicing this debt would be even easier if inflation were greater, as long as the borrower’s income kept up with inflation. Of course, the lender’s real income drops as a result. When nominal interest rates aren’t adjusted for inflation, some people gain and others lose purchasing power.
While strong inflation is bad for business, deflation, or declining prices, is also bad. When prices are falling, buyers postpone purchases if they can, hoping for lower prices later. For the economy, this translates to reduced economic activity, lower producer income, and slower economic growth.
The majority of economists today agree that low, stable, and, most importantly, predictable inflation is beneficial to a country’s economy. When inflation is modest and predictable, it is easier to capture it in price-adjustment contracts and interest rates, which reduces the distortionary effects. Knowing that prices would rise slightly in the future encourages customers to buy now, boosting economic activity. Inflation targeting is a policy adopted by several central banks with the primary goal of ensuring low and stable inflation.
What creates inflation?
Lax monetary policy is frequently the cause of long-term high inflation. The unit value of a currency decreases when the money supply grows too large in relation to the size of an economy; in other words, the currency’s purchasing power decreases, and prices rise. The quantity theory of money is one of the oldest ideas in economics, and it describes the relationship between the money supply and the size of the economy.
Inflation can also be caused by supply or demand-side pressures. Supply shocks that disrupt production or boost production costs, such as high oil prices, can limit total supply and contribute to ‘cost-push’ inflation, in which the motivation for price rises originates from a disturbance in supply. The global economy was hit hard by food and fuel inflation in 2008, as steeply rising food and fuel prices were passed from country to country through trade. Demand shocks, such as a stock market boom, or expansionary policies, such as when a central bank reduces interest rates or the government increases expenditure, can enhance general demand and economic growth momentarily.
If, on the other hand, demand rises faster than an economy’s capacity to meet it, the consequent strain on resources is reflected in ‘demand-pull’ inflation. Policymakers must strike the correct balance between supporting demand and growth when necessary while avoiding overstimulation and inflation.
Inflationary expectations are equally important. People and businesses include increased prices in pay negotiations and contractual price changes if they predict higher pricing (such as automatic rent increases). This behavior influences inflation in the next period because expectations become self-fulfilling once contracts are fulfilled and salaries or prices rise as agreed. And, to the extent that people’s expectations are based on the recent past, inflation will follow similar patterns over time, leading to inflation inertia.
How do policymakers deal with inflation?
The best disinflationary policies, or those targeted at lowering inflation, are determined by the causes of inflation. If the economy has overheated, central banks can use contractionary measures to cool it down, usually by raising interest rates, if they are devoted to price stability. Some central bankers have attempted to enforce monetary discipline by fixing the exchange rate—tying the value of their currency to that of another currency, and hence their monetary policy to that of another country—with different degrees of success. When inflation is driven by global rather than domestic factors, however, such interventions may not be effective.
When worldwide inflation rose in 2008 as a result of high food and fuel prices, several countries allowed the higher global prices to trickle down to their domestic economies. In rare circumstances, the government may set prices directly. In most cases, administrative price-setting measures result in the government incurring huge subsidy costs to compensate producers for lost income.
As a weapon for reducing inflation, central bankers are increasingly depending on their capacity to influence inflation expectations. Policymakers proclaim their plan to temporarily reduce economic activity in order to lower inflation, in the hopes of influencing inflation expectations and contracts’ built-in inflation component. The stronger the impact of central banks’ pronouncements on inflation expectations, the more credibility they have.
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