What is Inflation? What Causes It and Its Effects, 4 Examples of Inflation

Key takeaways:

• The rate at which prices for goods and services increase is known as Inflation

• It can be categorized into three main types – demand-pull, cost-push, and built-in.

• It can be either positive or negative, depending on the rate of change and individual viewpoint.

What is inflation?

The measurement of price changes of individual products over time is very easy to measure. However, human needs aren’t limited to just one or two products. They need a diversified set of products and services to lead a comfortable life. These can include products such as fuel, metal, and food grains, services such as labor, entertainment, and healthcare, and utilities such as transportation and electricity.

Inflation refers to the quantitative measure of the rate at which the average price level of a set of selected goods and services increases over a period of time. In other words, it is the increase in the general level of prices where a unit of currency buys less than it did in previous periods. It is the rate at which the general level of goods and services is rising and the purchasing power of a currency is falling.

The formula for calculating it is expressed as:

Inflation = [{Price(year 1) – Price 2(year 2)}/Price (year 1)] *100

What causes inflation?

The crucial cause of inflation is an increase in the supply of money. However, this scenario can play out in different ways in different economies.

No matter what the scenario is – money ends up losing its purchasing power. Therefore, the causes of inflation can be divided into three types – demand-pull, cost-push, and built-in.

Demand-Pull Effect

Inflation due to the demand-pull effect occurs when the supply of money and credit increases and stimulates the overall demand for goods and services to increase more than the economy’s production capacity. As a result, prices rise due to the increasing demand. If people have more money, it results in positive consumer sentiment. This results in higher spending, which further increases prices. As a result, a demand-supply gap is seen with higher demand but less flexible supply.

Cost-Push Effect

Inflation due to the cost-push effect occurs when prices increase through the production process inputs. The cost of intermediate goods tends to rise when the added supply of money and credit is fed into a commodity or other asset markets. This is more likely when there is a negative economic shock to the supply of key commodities. This leads to higher costs for a finished product or service which increases consumer prices.

Built-in Inflation

Built-in inflation refers to the idea that people are expecting current inflation rates to continue in the future. Due to the price of goods and services rising, people may expect it to continue at a similar rate. In such circumstances, workers may demand more wages to maintain their standard of living.

Effects of Inflation

It affects almost everyone in some way or the other, be it consumers, investors, or the overall economy. Here are some of the most common effects on any economy.

Decreases purchasing power

An overall increase in prices over time can decrease the purchasing power of consumers as a fixed amount of money will afford less consumption. Consumers lose purchasing power when it is at 2% or 4%.

Effects the poor disproportionately

People in the low-income bracket tend to spend a higher proportion of their income on necessities and, thus, have less of a cushion against the loss of purchasing power. However, those who receive Social Security benefits and other federal transfer payments receive inflation protection in the form of cost of living adjustments.

Increases interest rates

Governments and central banks everywhere need to keep inflation in check, generally by using monetary policy. Inflation threatens to exceed a central bank’s target rate. Under such circumstances, policymakers can raise the minimum interest rate which increases borrowing costs as it constrains the money supply.  As a result, inflation and interest rates move in the same direction.

Lower debt service costs

New borrowers face higher interest rates when it increases. However, those with fixed-rate mortgages and other types of loans tend to benefit from repaying them in inflated money. This lowers their debt service costs after an adjustment.

4 Easy Examples

To help readers understand this concept better, we have come up with four examples.

Example #1

Say a consumer can purchase a burger for $2 in 2022. The yearly inflation rate is 10%. Theoretically, this means that under 10% inflation, the same burger will cost 10% more, ie. $2.20.

Example #2

A historical example of would be Hungary, which in 1946 experienced the worst case scenario for its currency at the time. The inflation rate was well over 200% a day and prices doubled almost every 15 hours. In such cases, the only solution for a country is to abandon the existing currency and introduce a new one – which is exactly what Hungary did.

Example #3

Let’s say that the price of a book was $20 in 2016 (year 1) and the price increased to $20.50 the next year.  Thus by using the formula, the annual inflation is 2.5 %.

Example #4

Let’s say consumer prices went up by 8.5% over the last 12 months since the end of March 2022. Thus, a carton of eggs which was worth $3 is now $3.26.

Conclusion

From the aforementioned, we have gathered the significance of inflation in any economy.

FAQs

Why can’t the target inflation rate be less than 2%?

The target rate isn’t set close to zero as it may cause people to stop buying things if they think prices are going down.

How does inflation differ from deflation?

In inflation, prices of goods and services increase while the purchasing power of people decreases. In deflation, prices of goods and services decrease.

Is inflation a good or bad thing?

When it reaches high rates, it can be harmful to an economy. However, too little of it can cause the economy to weaken.