Table of Contents:
- Inflation explained: Understanding how it works
- Types of inflation
- Measuring inflation
- Inflation pros and cons
- FAQs about inflation
- The bottom line
With the COVID-19 pandemic and other world events, you may have felt the impact of inflation, whether it be while filling your gas tank, grocery shopping, or seeing a sudden rise in rent prices. However, how does price inflation impact everyday living, and what does inflation mean?
Inflation measures the increase of prices for goods and services in an economy over a period of time. When prices rise in an economy, it can impact the everyday lives of people and how they are able to live. Ultimately, inflation impacts consumers’ purchasing power for goods and services and can occur in any product and/or service found in our day-to-day lives, such as utilities, food, housing, and medical care. In addition to inflation impacting necessities, it can also drive up the prices of luxury items, such as cosmetics, cars, jewelry, etc.
When an economy is affected by rising or higher prices, central banks, such as the Federal Reserve in the U.S., observe the inflation rate and its impact on society. Because inflation has the potential to negatively affect society as a whole, it can quickly become a concern to consumers, as they have less disposable income to maintain their lifestyle, cover everyday expenses, and even save for retirement. In addition, inflation can also impact the sustainability of businesses.
While inflation results in rising prices, how does deflation differ from this? Let’s take a deeper dive into the two.
Key Takeaways:
- Inflation meaning in economics: Inflation is when the prices for goods and services in an economy rise over a period of time.
- Deflation is when prices decrease in an economy resulting from an increase in the value of money and purchasing power over time.
- Inflation causes can be categorized into 3 types: demand-pull inflation, cost-push inflation, and built-in inflation.
- Some of the most common ways to measure inflation include using the consumer price index (CPI), the producer price index (PPI), the personal consumption expenditures price index (PCE), and the wholesale price index (WPI).
- Inflation and whether it’s good or bad can be subjective to the individual, other dependent factors, and its rate of change.
Inflation vs. deflation
While inflation is defined as a rise in prices and a fall of purchasing power over time, deflation, on the contrary, is when prices decrease in an economy, which is the result of an increase in the value of money and purchasing power over time.
Similar to inflation, deflation can affect the costs of goods and services. When looking at deflation from a higher level, it can be seen as a benefit to consumers’ ability to purchase more goods and services at a lower cost. However, it can also raise concerns for economists. If deflation continues in an economy, economists may see this as an issue, especially in the financial sector. When prices continue on a downward trend, it can impact individuals who have loans or who have borrowed money. This means that debt-payers during deflation can ultimately be paying back money that’s worth more than it was when initially borrowed. This can result in an increase in interest rates and the overall value of their debt, which can lead to a halt in spending.
When there’s a drastic decrease in spending in an economy, it can cause an imbalance in the production or amount of goods and services compared to the amount of money being spent on those goods and services. The outcome of a major decrease in spending can lead to a rise in unemployment, a recession, and a reduction in wages and production in a society. Contrarily, a price rise in goods and services can also promote less spending in an economy, resulting in a stagnation of the circulation of money and economic growth.
Now that we’ve covered how the inflation economics definition differs from deflation, let’s move on to a true understanding of how inflation works.
Inflation explained: Understanding how it works
In order to explain inflation in more depth, it’s essential to understand what inflation means beyond changes in the price of products individually, and how the measurement of price changes across a diversified group of products and services plays a role in minimizing the impact of inflation as a whole.
Since consumers count on products and services that provide them with the basic necessities and even luxuries to live a well-balanced and healthy lifestyle, the goal of inflation is to measure these products and services in various groups. As mentioned earlier, high inflation rates can impact the cost of living, resulting in slow economic activity or a lack of economic growth. Moreover, a lack of economic growth or inflation can cause more growth in the money supply of an economy than the actual demand for products and services. To prevent this, the central bank of a country may look at the overall relationship between the money supply and inflation in an economy. While monetary policy controls the supply of money in an economy and how it is distributed amongst consumers, banks, and financial institutions, it’s used as a tool to sustain economic growth. It’s also one of the factors that play a role in monetarism.
Monetarism is a macroeconomic theory that states that the total sum of funds issued by the government should be at a stable and productive pace and should only increase to promote healthy economic development. Milton Friedman, an American economist closely associated with the theory of monetarism, stated that rather than focus on the supply of money, it’s more important to focus on the maintenance of price stability in an economy, which is a steady balance between money supply and demand.
In February 2022, the inflation rate had the largest 12-month increase that it has had since July 1981. However, we’ll cover this in a later section and also look at other causes of inflation and how it impacts bullish or bearish price changes.
Rising inflation example
Annual Average Movie Ticket Prices Over Time
1975 $2.03
1976 $2.13
1977 $2.23
2010 $7.89
2011 $7.93
2012 $7.96
2013 $8.13
2014 $8.17
2015 $8.43
2016 $8.65
2017 $8.97
2018 $9.11
2019 $9.16
When going beyond the definition of inflation or considering further how to define inflation, you may wonder how inflation has individually impacted a product or service over time. In the photo example, you can see how inflation has impacted the change in movie ticket prices from 1975 to 2019. The National Association of Theatre Owners (NATO) collected data from the NATO survey and the Consumer Price Index for Urban Wages and Earners and Clerical Workers (CPI-W) to observe the price change in movie tickets from 1948 to 2019. In 1975, the annual average ticket price was $2.03. In 2019, the movie ticket price had more than doubled to $9.16.
Hyperinflation example
Examples of extreme inflation rates can also be found throughout history. Some of the most extreme cases include the 2008 hyperinflation crisis in Zimbabwe. During March 2007, Zimbabwe entered hyperinflation, and in 2009, it was completely forced to relinquish its currency due to the loss of purchasing power. Before Zimbabwe’s hyperinflation period, it was a resource-rich country and considered successful. During Zimbabwe’s independence, its annual inflation rate was 5.4% with a 0.5% average monthly inflation rate. The Z$20 and the Zimbabwean dollar were the largest and most used currencies in over 95% of transactions. However, during its hyperinflation period, Zimbabwe was met with exceeding government debt and a major decrease in output. Between 2000 and 2009, the output decreased by 50%.
Other factors that contributed to Zimbabwe’s economic demise included the fall of its foreign-exchange cash crops including tobacco and corn, known as its national staple. These contributing factors and Zimbabwe’s uncontrollable debt led to the printing of additional money to try and recover from its failing economy. The outcome was a hyperinflation period that reached an annual inflation rate in September 2008 of an estimated 489 billion percent and in November of 2008, 7.66 x 1012 % with a 98% daily inflation rate. During the peak of Zimbabwe’s hyperinflation period, prices doubled every few days. By the end of the fall of what used to be a rising economy, individuals were wiped from wealth and forced into poverty. In addition, some were forced to emigrate. From 2007 to 2008, the Zimbabwean currency lost 99.9% of its value and was omitted and replaced with foreign currencies. Similar to Zimbabwe’s hyperinflation crisis, other examples throughout history include Germany, Hungary, and Argentina.
Types of inflation
There are many varying factors that contribute to the cause of inflation. An extensive period of inflation can be a result of a negligent monetary policy. In addition, when the money supply in an economy exceeds the actual size of an economy, this not only devalues the currency and its purchasing power, but it increases the costs of products and services. In addition to these components of inflation, inflation can be categorized into 3 types, which include demand-pull inflation, cost-push inflation, and built-in inflation. Let’s review how these types of inflation happen.
Demand-pull inflation
Demand-pull inflation can occur when there’s huge consumer demand for a product or service. When there’s a strong surge for varying goods and services in an economy, this creates huge pressure for this demand and causes prices to rise. It can also create an imbalance between the actual demand for goods and/or services and the production capacity. This imbalance of higher demand and reduction in supply creates a demand-supply gap and results in demand-pull inflation.
Cost-push inflation
Cost-push inflation occurs when prices rise throughout the production process. The rise in production costs can be seen in things like the price of raw materials and wages. While the demand for goods and services stays the same, the supply of goods and services is reduced due to the increase in production costs. Naturally, this translates into a higher cost of the finished product and/or service for consumers.
A similar example of this can be seen in the current state of gas prices. When the supply of oil is tightened, and other sources of oil are cut off, this creates a limited oil supply. However, the demand for gas stays the same. This is not only impacted by the rising costs to acquire oil from a business standpoint, but it can also result in a higher cost that consumers are met with when filling up their gas tank.
Built-in inflation
Built-in inflation can occur when there are consumer expectations that inflation will continue in the future due to its current state. When the prices for goods and services are on a constant increase, this affects the livelihood of individuals and how they are able to provide for themselves. Because of this, consumers demand higher wages to account for the higher cost of living. This ultimately creates a higher price for goods and services, and each factor can continue to affect the other.
Understanding the effects of bull markets and bear markets can also contribute to a better understanding of inflation and how price changes and trends in our economy affect the stock market.
Measuring inflation
So, how do we measure inflation? Some of the most common ways to measure inflation are by using the consumer price index (CPI), the producer price index (PPI), and the personal consumption expenditures price index (PCE). The consumer price index (CPI) measures the price of a basket of goods and services over time that’s commonly purchased by consumers. This basket can include things like rent and mortgages, food, cars, education, and recreation. Since consumers make varying purchases across a diverse range of goods and services, government agencies collect data from a household survey to find these commonly purchased goods and services to create a basket of items. The price of the basket of commonly purchased items is measured over time. The U.S. Bureau of Labor Statistics reported that the consumer price index (CPI) from February 2021 to February 2022 increased by 7.9%, and in January 2022 had a 12-month increase of 7.5%. The food prices rising to a 12-month increase of 7.9% in February 2022 was the largest 12-month increase that has occurred since July 1981. In addition, from February 2021 to February 2022, energy prices rose by 25.6%.
The producer price index (PPI) measures the costs for materials like fuel, farm materials, such as meat and grains, chemical products, and metals and reports the changes in these prices that ultimately affect domestic producers. If the PPI rises and it affects consumers, it’s shown in the CPI. The wholesale price index (WPI) is another common form of measurement that keeps track of the price changes of goods before it heads to retail. Some of these goods include things like the price of cotton clothing, raw cotton, etc.
Lastly, similar to the CPI, the personal consumption expenditures price index (PCE) measures the costs of goods and services. However, the difference between the two is that the CPI collects information from consumers, while the PCE collects information from businesses.
Inflation rate definition & formula
Although there are many ways to measure inflation, the CPI inflation rate formula can be determined by the CPI of the next year subtracted from the consumer price index of the initial year, divided by the consumer price index of the initial year. Let’s take a look at the formula below.
(CPIx+1 – CPIx)/CPIx = Rate of Inflation Formula
CPIx = Consumer price index of the initial year
CPIx+1 = Consumer price index of the next year
Inflation pros and cons
It may come as no surprise that the benefits of inflation are scarce for consumers. However, such benefits can be subjective and dependent on what side of the coin you land on. Some investors may benefit from inflation due to the possible increase in their assets. For example, if an investor chooses to invest in a company whose industry is affected by inflation, this rise can be reflected in their investment portfolio.
Let’s say you invest in a company that’s in the oil and gas industry. If oil and gas prices rise, this could potentially affect the increase in the price of your stock. Inflation may also benefit businesses if they have a huge demand for a product. A business can reap the benefits if their demand for their product is higher than the production costs or the production costs stay the same. This demand can allow for businesses to charge higher prices to their consumers. When profit margins increase, this gives a business pricing power and results in the company’s ability to charge more for their product, where their product costs increase more than their production costs.
On the other hand, inflation can have a negative impact on the overall economy, which can affect businesses, consumers, and workers. High inflation can create uncertainty in society and can result in a halt in growth and stability in an economy from less spending. In addition, inflation can affect the livelihood of individuals through a reduction in wages and income. As mentioned earlier, the inflation rate can also impact interest rates. This means that if the inflation rate rises, it can cause a rise in interest rates, which ultimately can affect the borrower or even those who count on their savings. Overall, our previous historical example shows that inflation has the ability to destroy an entire economy, which can impact everyone, including businesses, consumers, and workers, and can interfere with people’s way of living.
Managing Inflation
Now that we’ve covered the many topics of inflation, including how to define inflation rate, how it works, and how to measure it, let’s dive into how to manage inflation. Inflation and its causes can determine the measures taken to combat it. However, the financial regulators of a country determine what best steps are necessary to manage inflation. Monetary policy, as mentioned earlier, is a tool used to combat inflation and maintain a growing economy. Through monetary policy, the Federal Reserve may determine the measures for 3 area-specific goals, which are price stability, interest rates, and maximum employment. These specific objectives can promote a financially stable economy. The Federal Reserve creates long-term goals that support its effort to produce a steady rate of inflation throughout the economy over time. In addition, policymakers in the U.S. have made an effort to maintain an inflation rate of 2% each year.
Many economists believe that a good economy is a result of a low, stable, and predictable inflation rate, which is also known as inflation targeting. Inflation targeting is a strategy used by central banks that focuses on maintaining price stability by targeting a specific inflation rate and implementing measures to support it.
FAQs about inflation
- Are there other types of inflation?
In addition to inflation and deflation, other types of inflation include hyperinflation, stagflation, and disinflation.
- Is inflation a good or bad thing?
As mentioned earlier, inflation can have a few benefits for certain businesses and possibly investors. On the other hand, inflation can pose a bigger risk to the health of an economy as a whole when it’s not managed properly. However, if controlled, low and steady inflation can be seen as good for the economy. Inflation and whether it’s good or bad can be subjective to the individual, other dependent factors, and its rate of change.
- How does inflation affect the stock market?
Learning about how stocks work and stock market hours can help with understanding the overall stock market. An investor’s investment in growth stocks or value stocks can determine the projector of their performance during inflation. While high inflation may have more of a benefit on value stocks, low inflation may have more of a benefit on growth stocks. However, high inflation, in general, can signal a more volatile stock market.
The bottom line
While we define inflation as the measure of the increase of prices for goods and services over a period of time, there are many variables to managing, reducing, or combating it in an economy. When managed properly and maintained at a low and stable rate, inflation can be seen as beneficial to an economy. However, when uncontrolled, it can become impossible to recover from, and it can affect the financial health of an economy. When investing in the stock market, it’s important to understand how inflation not only impacts the stock market, but also how it impacts your investment portfolio. In addition, speaking with a professional financial advisor and researching how to manage your investments during high periods of inflation can be beneficial for creating an investment strategy that works best for you. Sign up now by downloading the Public App to learn more!