Inflation is a term we often hear in economic discussions, but what does it truly mean? In this article, we’ll discuss what it is: its causes, its effects on individuals and the economy, and ways to prevent it.
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What is Inflation?
Inflation refers to the rate at which the general level of prices for goods and services rises over a period of time, resulting in a decrease in the purchasing power of money.
What Causes Inflation?
There are several reasons why it may occur, such as rising labour and raw material costs or disruptions in the market. It may also result from higher demand, and some monetary and fiscal policies, like reduced taxes or interest rates, may also be contributing factors.
The Federal Reserve in the United States and other central banks in developed nations keep an eye on inflation. When It happens too quickly can make the cost of essentials unaffordable.
Additionally, it devalues currency, reduces consumer purchasing power, and may make it more difficult to save money.
Although there are many causes of it, they can be broadly divided into two categories: cost-push and demand-pull inflation. Let’s break these down:
1. Demand-Pull Inflation
This occurs when the demand for goods and services exceeds supply. Common causes include:
- Economic Growth: When an economy grows rapidly, increased consumer spending can drive up prices.
- Government Spending: Excessive government expenditure on infrastructure or social programs can inflate demand.
- Monetary Policy: Low interest rates encourage borrowing, leading to higher spending and increased demand.
Example: During the post-pandemic recovery in 2021, many countries experienced demand-pull inflation due to increased consumer spending and supply chain disruptions.
2. Cost-Push Inflation
Cost-push inflation happens when production costs rise, compelling businesses to pass on these costs to consumers. Key drivers include:
- Rising Raw Material Costs: Increased prices for oil, metals, or agricultural products can inflate production costs.
- Wage Growth: Higher wages increase the cost of production for companies.
- Currency Depreciation: A weaker currency raises the cost of imported goods.
Example: The surge in global oil prices in 2022 caused transportation and production costs to soar, leading to cost-push inflation in many countries.
Other Contributing Factors
- Built-In Inflation: When workers demand higher wages to keep up with rising costs, creating a cycle of wage and price increases.
- Excess Money Supply: When central banks print more money than the economy needs, it dilutes the value of currency.
How Is Inflation Measured?
To monitor it level, economists employ particular indicators. The most commonly used measures include:
1. Consumer Price Index (CPI)
Among the most widely used is the Consumer Price Index (CPI), which calculates the costs of a variety of economic goods and services, such as food, automobiles, leisure, and education.
As a result, changes in this basket’s prices roughly reflect changes in prices throughout the economy. The CPI is often the economic indicator of choice used for measuring inflation.
Although the CPI tracks changes in retail prices and other consumer-paid items, it misses savings and investments, and it frequently does not account for foreign visitor spending.
2. Producer Price Index (PPI)
The Producer Price Index (PPI) is another indicator of inflation that tracks changes in prices that impact domestic producers.
The PPI tracks the costs of metals, chemicals, fuel, and agricultural goods like meats and grains. The Consumer Price Index will reflect price increases that result in a spike in the PPI if they are passed on to customers.
Since the PPI is the average selling price that producers receive for their output over time, it calculates inflation from their point of view. Meanwhile, CPI measures prices from the standpoint of the consumer.
3. Core Inflation
Core inflation excludes volatile items like food and energy, offering a clearer view of long-term inflation trends.
The Effects of Inflation on Everyday Life
Inflation impacts everyone, but its effects vary depending on individual circumstances. Here’s how:
1. Reduced Purchasing Power
As prices rise, the same amount of money buys fewer goods and services. This particularly affects individuals on fixed incomes.
2. Eroded Savings
High inflation reduces the value of money saved in bank accounts, especially if interest rates are lower than the inflation rate.
3. Increased Cost of Living
Daily expenses such as groceries, rent, and utilities become more expensive, straining household budgets.
Example: In 2023, many households worldwide faced higher grocery bills due to inflation, prompting changes in spending habits.
What Are Some Ways to Prevent It?
To control its effect, governments can use a variety of tools. The most common option for a central bank is to raise interest rates.
This is a contractionary monetary policy, which lowers the money supply and restricts the spending of both individuals and businesses by raising the cost of credit.
It can be lowered through fiscal actions like tax increases. In the past, governments have also attempted, with varying degrees of success, to limit the price of particular goods through measures like price controls.
Conclusion
When an economy’s prices increase and or money’s purchasing power declines, inflation takes place. Rising wages as well as an increase in the money supply and aggregate demand are some of the potential drivers of inflation that economists have identified.
International and U.S. inflation rates reached their highest points since the early 1980s in 2022.
Although there isn’t a single cause for the sharp increase in prices around the world, a number of factors, such as the COVID-19 pandemic’s aftermath, Russia’s unprovoked invasion of Ukraine, and the ensuing shock to oil and food prices, combined to drive it in its most recent cycle.
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