Inflation

Inflation

Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.

KEY TAKEAWAYS

• Inflation is the rate at which the value of a currency is falling and, consequently, the general level of prices for goods and services is rising.
• Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
• The most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
• Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.
• Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.

Understanding Inflation

While it is easy to measure the price changes of individual products over time, human needs extend beyond one or two such products. Individuals need a big and diversified set of products as well as a host of services for living a comfortable life. They include commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like healthcare, entertainment, and labor.

Causes of Inflation

An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, by legally devaluing (reducing the value of) the legal tender currency, more (most commonly) by loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market.

In all such cases of money supply increase, the money loses its purchasing power. The mechanisms of how this drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Effect

Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy’s production capacity. This increases demand and leads to price rises.

With more money available to individuals, positive consumer sentiment leads to higher spending, and this increased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible supply, which results in higher prices.