Any currency's purchasing power can decrease over time. A quantitative measure of the rate of purchasing power decrease is called inflation. In economics, inflation can be observed in the increase of the average price level for a basket of certain goods and services during a certain period of time. Price increases are presented as a percentage. It means that it is actually possible to buy less for a unit of currency than in previous periods of time. Inflation is the opposite of deflation (a money purchasing power increase, a decrease in prices).
Changes in prices over a period of time for certain goods are easy to track, but anyone uses more than 1-2 goods and a person's needs can grow. Comfortable human life necessitates a large and diverse set of goods (food, metals, fuel, etc.) and services (health care, electricity, transportation logistics, utilities, entertainment, and labor).
Inflation is expressed as a single value representing the impact of price changes on a diversified set of goods and services. Inflation is calculated from the increase in the price level of goods and services in an economy over a period of time.
The May 2022 CPI-U (Consumer Price Index for Urban Consumers) was the highest annual value. It was 8.6%. Such an index has not been seen since 1981.
Economists claim that persistent inflation requires monetary growth outpacing economic growth.
When prices rise, the value of the currency falls and less goods and services can be purchased for it. Economic growth slows down when the general cost of living increases, due to the loss of currency purchasing power.
A specialized monetary authority of a country (e.g., the central bank) acts to counteract inflation. Money and credit supply are managed to provide the economy with smooth operation and to keep inflation within acceptable limits.
A quick increase in the money supply leads to a fall in the value of money and a rapid rise in prices.
There are different ways to measure inflation. The method depends on the type of goods and services. On the contrary, deflation indicates a general decrease in the prices of goods and services when the inflation rate falls below 0%.
Causes of Inflation
The fundamental cause of inflation is an increase in money supply by any economic methods. And the money supply in a country can be increased as follows:
- The most common method is to create credit in the banking system for reserve accounts to borrow new money (buying government bonds from banks on the secondary market).
- The production and issuance of more money.
- The value reduction (devaluation) of a country's payment currency.
The purchasing power of money decreases for any of these reasons. The main mechanisms of inflation can be divided into three types: demand-pull inflation, cost-push inflation and built-in inflation.
Usually, changes in the price level are explained by excess total demand, i.e., production cannot provide enough goods and services that people are able to consume. In the consumer market, the money supply exceeds the real value of goods offered for sale.
The productive sector is unable to respond to this excess demand by an increase in real output, because all available resources have already been completely used. Therefore, this excess demand leads to inflated prices for a constant, real volume of production and causes demand inflation.
The idea of demand inflation is sometimes explained in one phrase: "Too much money hunts for too few goods.
Sometimes in an economy, total demand is lower than supply, i.e., the value of offered goods and services exceeds the people' consumption. According to the free market the prices of goods and services should fall. But this does not happen. Instead of the expected fall in prices, there is a rise in prices.
At a constant level of production, this is possible due to the increase in costs per unit of production, or when the growth of costs exceeds the growth of production. As a result, producers' income is reduced by reducing the level of profitability. The producer is forced to raise prices for their products to avoid losses.
Salary inflation is a type of cost-push inflation. If countrywide salary increases are not balanced by any counteracting factors, such as an increase in output per hour, then unit costs will rise. Producers will reduce the production of goods and services put on the market. With unchanged demand, this will lead to an increase in the price of goods, and hence an increase in inflation.
Built-in inflation is about adaptations. People expect the current rate of inflation will remain the same in the future. Spending to maintain living standard increases and salaries are expected to rise, when there is a rise of goods and services prices. Higher salaries cause the rise in the cost of goods and services. This salary-price spiral continues because one factor triggers another and vice versa.