What “Inflation” is? And When Does it Good for You?

Inflation

We hear about it all around us. It’s in the newspapers or on the news, and not only in economics contexts. But what exactly “Inflation” is? Does it good for us? If so, why? One of the most important concepts in economics is also one of the simplest to understand.

# What “Inflation” is?

By definition, inflation is the increase in the general level of prices. For example, in the ’90s the price for urban bus ride probably was much less than what it is today. Why? The answer is Inflation- a process of degradation in the value of the local currency. When people say “Once the things were cheaper…”, they actually mean to inflation: With the same amount of money, you could have bought more than what you can today.

# How to Measure Inflation?

The Bureau of Labor Statistics created something called the “Consumer Price Index”. They defined a basket of goods and services, which made up of what they define as “what the average urban consumer needs in his life”. This includes housing, fuel, transportation, etc.  Then, they figure out how much that would cost them in year One. Let’s say for simplicity that the basket costs $100 in year One. Then, they will look at the same basket each year after that, checking the price of the same things- Housing, fuel, services, transportation.

Let’s assume that the same basket costs $102 in year Two. Then we’ll say that the general level of price and services went up by two dollars. Or, more importantly- went up by two percent. So, based on this measure, this basket of goods, prices went up by two percent. A thing to notice here that usually when we talk about inflation, we mean price inflation- as discussed here. But inflation can be caused by the central bank printing money- which increases the money supply. Increased money supply means more money for people to have. The more money people have – the more money they are willing to spend, therefore more demand for products, which causes prices to increase.

 

# Problems Measuring the Basket

Think about it- your phone, or any technological thing you might have, is the same as it was 10 years ago? Probably not. If you look at the same TV for example, it probably got much cheaper than what it was 10 years ago. So how can they measure the price for technological things? They simply take the average TV set/computer/technological item that the American household is having. But, do you see the problem here? It is a different product! So, there’s actually a lot of things to think about when we talk about measuring inflation and a lot of ways for us to measure the basket of products and how to weight it. There’s been a lot of controversy about that subject, but this is a general idea and the best attempt to figure out on average how much more expensive or how much purchasing power we are loosing from one year to the next.

# Why the Government Encourages Inflation?

The central banks in the western countries have defined an annual inflation destination of ~2%. Why is that? The answer is simple- because they want the markets to grow! When the economic activity is growing and improving over time- people will buy more. When people buy more- the sellers increase the prices of their products. It is that simple. When the economy moves forward the prices go up naturally. Population growth is also a positive signal- the more people, the more demand, the more production. So as long as the wages go up along with the increasing rate of prices, the standard of living remains the same and the economy is in a healthy condition.

# How can Negative Inflation Hurt us?

Negative inflation, or even zero inflation, is not a healthy situation for the markets. In this situation, people will rather save money instead of buying stuff, thinking that the value of their money will increase over time (think about it- the level of prices decreases- so you might think “maybe I’ll wait with that new TV, it may get cheaper in the next few months”), and so the economy stuck. This will lead to the central bank decreasing the interest rate encouraging the people to consume and buy more- which might increase the housing prices and decrease the returns on your savings.

 

Summary

  • Inflation is caused because of increased demand. The increased demand for products makes their prices to rise.
  • Demand is simply the cause of people willing to spend more (or there is a growth in the number of people who are willing to spend).
  • People will be willing to spend more if their wages rise, or if they feel richer (maybe low-interest rates that cause people to take more loans and make them feel richer).
  • By definition, inflation is the increase in the general level of prices. The continuous process of the local currency’s erosion.
  • “Healthy Inflation” stands for about 2%, encourages us to consume and buy. Growing the market.
  • If our wages would have been CPI linked, our standard of living wouldn’t be hurt by high inflation.
  • A low inflation rate is a healthy condition of the market. Signaling a healthy economy and increased demand for products.
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