What Is Inflation, Know Its Causes, Pros & Cons, and More

Inflation is a rise in prices, which over time can be translated into a decline in purchasing power. The rate at which purchasing power falls may be reflected in the average price increase of a basket of selected goods and services over a given period.

An increase in prices often expressed as a percentage, means that a unit of currency effectively buys less than in previous periods. Inflation can be compared to deflation, which occurs when prices fall and purchasing power increases.

Causes of  Inflation

An increase in the money supply is the root of inflation, although it can operate through a variety of mechanisms in the economy. The money supply of a country can be increased by the monetary authority of:

  • printing and giving more money to citizens
  • Legally devalue (lower the value) of legal tender currency.
  • Bringing new money into existence in the form of reserve account credits through the banking system by purchasing government bonds from banks on the secondary market (the most common method)

In each of these scenarios, money loses its ability to spend. As a result, three different types of inflation mechanisms can be identified: demand-pull inflation, cost-push inflation, and built-in inflation.

The Formula for Measuring Inflation

The above-mentioned forms of price index can be used to calculate the value of inflation between two particular months (or years). While there are many ready-made inflation calculators already available on various financial portals and websites, it is always better to be aware of the underlying methodology to ensure accuracy with a thorough comprehension of the math. Mathematically,

Percentage Inflation Rate: (Final CPI Index Value / Initial CPI Value) x 100

Suppose you want to know how the purchasing power of $10,000 changed between September 1975 and September 2018. One can find price index data on various portals in tabular form. From that table, select the relevant CPI figures for the given two months.

For September 1975, it was 54.6 (the initial CPI value) and for September 2018, it was 252.439 (the final CPI value). 

Percent Inflation Rate: (252.439/54.6) x 100 = (4.6234) x 100 = 462.34%

Since you want to know how much $10,000 would be worth from September 1975 through September 2018, multiply the amount by the inflation rate to get the converted dollar value;

Change in Dollar Value: 4.6234 x $10,000 = $46,234.25

This means that $10,000 would be worth $46,234.25 in September 1975. Essentially, if you bought a basket of goods and services (as included in the CPI definition) worth $10,000 in 1975, that same basket would have cost you $46,234.25 in September 2018.

What Is the Reason for the Inflation?

inflation

There are three main causes of money: demand-driven money, cost-driven money, and built-in money.

  • Demand-pull Inflation refers to representations where not enough products or services are being produced to keep up with the demand, thereby increasing sales.
  • On the other hand, cost-pull Inflation occurs when the cost of producing products and services increases, forcing consumers to increase their sales.
  • Built-in Inflation (which is sometimes referred to in the context of workers’ comp) occurs when workers make high staffing demands to keep up with the cost of living. This in turn causes its sales to perpetuate your increased salary spending, creating a self-reinforcing loop of increasing employees and wages.

Is Inflation Good or Bad?

Too much inflation is generally considered bad for an economy, while too little, is also considered harmful. Many economists advocate a middle ground of low to moderate inflation of around 2% per year.

Generally speaking, the high boom hurts savers because it eats away at the purchasing power of the money they save. However, it can benefit borrowers because the inflation-adjusted value of their outstanding loans decreases over time.

What Are the Effects of Inflation?

It can affect the economy in many ways. For example, if inflation causes a country’s currency to depreciate, this can benefit exporters by making their goods more affordable in the foreign country’s currency.

On the other hand, it could hurt importers by making foreign-made goods more expensive. High inflation can also encourage spending, as consumers aim to buy goods before prices rise further. Savers, on the other hand, may see the real value of their savings diminish, limiting their ability to spend or invest in the future.

The advantages and Disadvantages of Inflation

It can be understood as a good or a bad thing, depending on which side one takes and how fast the change occurs.

Pros

Individuals with tangible assets (such as property or stocked items) may prefer to see some inflation in their home currency as this increases the value of their assets, which they can sell at a higher rate.

It often leads to speculation by businesses in risky projects and by individuals. Investing in company shares because they expect better returns than inflation.

The optimal level of the boom is often promoted in order to encourage spending to a certain extent rather than saving. If the purchasing power of money falls over time, there may be more incentive to save and spend now rather than later. It can increase spending, which can boost economic activities in the country. It is believed that a balanced strategy will keep the rate of inflation within an ideal and acceptable range.

Cons

Buyers of such properties may not be happy with it, as they will need to spend more money. It may not be liked by those who own assets denominated in their native currency. Such as cash or bonds, as it reduces the true worth of their possessions.

As such, investors looking to protect their portfolios from inflation should consider. Inflation-protected asset classes, such as gold, commodities, and real estate investment trusts (REITs). Inflation-indexed bonds are another popular option for investors seeking to benefit from inflation.

High and variable rates of the boom can impose huge costs on the economy. Businesses, workers, and consumers should generally take this into account. The effects of rising prices in their buying, selling, and planning decisions. This introduces an additional source of uncertainty into the economy, as they may miscalculate about future inflation rates.

The time and resources spent on researching and estimating. And adjusting economic behavior is expected to cause prices to rise to normal levels. This is in contrast to real economic fundamentals, which essentially represent costs to the economy as a whole.

Even a low, stable, and easily predictable boom rate. What some otherwise consider optimal, can cause serious problems in the economy. This is because of how, where, and when the new money enters the economy.

Every time new funds or credit enter the economy, they are under the control of particular people or corporations. The process of price level adjustments to the new money supply occurs. As they spend the new money and it circulates through. The economy from hand to hand and from account to account.

Inflation First Raises Some Prices and Later Raises Other Prices

This gradual change in purchasing power and prices (known as the Cantillon effect) means that the process of this, not only raises the general price level over time.

Every time new funds or credit enter the economy, they are under the control of particular people or corporations. Economists, in general, understand the distortions of relative prices away from their economic equilibrium. These are not good for the economy, and Austrian economists believe. That this process is a major driver of recessionary cycles in the economy.

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