Inflation

Inflation happens when the prices of goods and services go up over time, which makes money less valuable. As a result, people need more money to buy the same things they could afford before. While a little inflation is normal, if prices rise too quickly, it can make life harder for people, especially those with low incomes. However, inflation isn’t just about how much money people earn. It also affects people’s ability to protect their money from losing value. Many people try to avoid the effects of inflation by moving their money into things like savings accounts, investments, or other financial tools that lose value more slowly than cash.

Inflation: first, the definition.

Inflation is defined as the generalized and sustained increase in the prices of goods and services in an economy. The two adjectives are relevant: because it makes us realize that neither the constant increase in the price of a given good, nor the increase of all goods all at once, can be considered inflationary phenomena.

How to calculate it?

In general, each country has a statistical institute that presents one or more indicators used to know the evolution of prices. The most widespread is usually the Consumer Price Index, which calculates the cost of a certain basket of goods and services that are representative of household consumption. In order to do so, it is essential that the basket be well weighted (i.e., that the prices of the most consumed goods weigh more in the indicator).

The variation rate of the price index between two periods shows the inflation rate and is a reflection of how much citizens' lives have become more expensive.

The nominal and the real

The existence of variations in the general price level forces us to distinguish between those increases that simply accompany the inflation rate, and those that do so above or below it. In other words, an increase in the level of one price (say, wages) may not tell us much about how much more (or less) that good or service represents in relation to others. That is why economists talk about nominal increases and variables (i.e., in number) and real increases or variables (how much more it is “worth,” or how its purchasing power changed). Thus, a 5% wage increase may be impoverishing workers (if the inflation rate is higher than 5%), or a 4% interest rate may be liquefying savings, if inflation is higher.

The causes

There is no unanimous or univocal consensus on the causes of inflation. In general, in each historical context, price acceleration may be due to other phenomena. However, a classification of “types of inflation” according to the factors driving it may be useful:

Demand inflation (monetarist view): there is an excess of the quantity of money in relation to what people want. This occurs when the Central Bank issues more money than production increases. As if in Monopoly we all get twice as many bills but with the same properties at stake... the only thing that can happen is that those properties double (in nominal terms) their value.

Demand inflation (Keynesian view): from a perspective inspired by the writings of John Maynard Keynes, inflation occurs once full factor employment has been reached. Unlike the monetarist view, Keynesians argue that a larger money supply can increase output (see the section on interest rates) without necessarily accelerating inflation. It is as if in monopoly you increase the banknotes while enlarging the board!

Cost inflation: there are some goods whose price is only relevant for consumers, but there are others that influence many sectors of the economy. Wages, the price of oil, or the exchange rate, are clear examples of the latter. If there is an increase in these, the whole economy is likely to be affected.

Inertia and the distributive push: once the inflation wheel starts to spin out of control, incentives are generated so that it does not stop spinning. Imagine that a workers' confederation manages to establish a wage increase for all sectors. If the employers then transfer this increase in costs to prices, workers will quickly find that the increase has not been of much use to them, and they will return to demand another increase. The same could happen with a devaluation aimed at improving a country's competitiveness. A vicious circle that is difficult to stop.

Is a little inflation a good thing?

While probably no one reading this text considers that rising price levels are desirable, there is a certain consensus among economists that low and controlled inflation can be a symptom of good health (especially in comparison to even more traumatic experiences of deflation). Moreover, since many prices are inflexible downwards, small levels of inflation allow relative prices to be accommodated without breaking the whole economy.

In any case, economic policy in general and monetary policy in particular is closely related to price stability (or not). That is why we address them in Pallicies!