Inflation: How Price Increases Shape Our Economy

What Really Happens When Prices Rise?

Have you noticed how much things have changed compared to the years of the past? This is not just a feeling. Inflation is an integral part of today's economy, and it affects the daily decisions of all of us. At its core, inflation describes the gradual decrease in the purchasing power of money – that is, over time, the same amount of money buys fewer things.

This phenomenon is neither coincidental nor random. It arises from imbalances between the demand and supply of goods and services. When more people want something than what is available, prices naturally rise. The difference is that inflation does not pertain to just one good – it affects almost everything simultaneously.

The Three Faces of Inflation

Understanding inflation becomes much easier when we recognize its different types. Let's start with a practical example that explains the dynamics.

When Demand Exceeds Supply: Demand-Pull Inflation

Imagine a local baker who produces 1,000 loaves of bread every week. For years, this amount was ideal – he sold everything he made. But suddenly, the economic situation in the area improves. People have more money to spend and start buying more bread, milk, oil, and other goods.

The baker is facing a problem: demand has tripled but his ovens are at their limit. He cannot produce more bread immediately – he needs time to expand his facilities. When there are many customers and insufficient stock, some are willing to pay more. The baker logically raises the prices. This is demand inflation – when human desire exceeds the available quantity, causing upward pressure on prices.

When Production Costs Rise: Cost-Push Inflation

Now, let's imagine that the baker has finally expanded his business. He produces 4,000 loaves a week and everything is running smoothly. However, one morning he receives bad news: this year's wheat harvest was disastrous. The supply of wheat has dramatically decreased across the region.

The baker is forced to pay significantly more for his raw materials. Demand has not increased – but the cost of the product has skyrocketed. To maintain his profit margins, he must raise his prices. On a large scale, this scenario is repeated across many sectors simultaneously. Shortages of raw materials, higher transportation costs, wage increases, and taxes – all contribute to cost inflation.

The Self-Sustaining Cycle: Inherent Inflation

There is a third type that is harder to understand. When people have experienced steady inflation for months or years, they begin to expect it. Workers demand higher wages to protect their income. Businesses raise their prices accordingly. This drives workers to demand even higher wages – and the cycle continues. This is inherent inflation: a self-sustaining phenomenon created by the expectation of inflation itself.

How Do We Measure Price Increases?

Before we can do anything about inflation, we need to measure it. Most governments use the Consumer Price Index (CPI) as the main measurement tool. The CPI is created by tracking the prices of a “basket” of goods and services purchased by households – bread, milk, electricity, rent, and others.

This data is periodically collected from thousands of stores and is used to calculate the index. A “base year” is defined with a score of 100. If, two years later, the score is 110, this means that prices have increased by 10% over time. This quantification is essential to understand whether inflation is under control or has spiraled out of control.

How Governments Control Inflation

When inflation begins to concern the authorities, they have two main tools: monetary policy and fiscal policy.

Monetary Policy and Interest Rates

Central banks control the amount of money in circulation and interest rates. When inflation rises, they increase interest rates, making borrowing more expensive. When loans are expensive, people borrow less and spend less. Decreased demand then drives prices down. It is a painful but effective tool.

Fiscal Policy

Alternatively, governments can raise taxes or cut public spending. This leaves households with less money to spend, reducing demand across a broad spectrum. However, these policies may be politically sensitive and create dissatisfaction.

The Advantages of Low Inflation

It may seem paradoxical, but low, stable inflation is actually beneficial for the economy. Firstly, it encourages people to spend and invest. Why save money today if it will be worth less tomorrow? This behavior boosts economic activity.

Secondly, inflation allows businesses to increase their profits without necessarily having to reduce wage rates. This promotes hiring and expansion.

Third, low inflation is favorable compared to deflation – periods during which prices fall. When prices fall, people delay their purchases, waiting for even lower prices. This stifles economic activity and can lead to unemployment.

The Problems of High Inflation

However, when inflation gets out of control, the results are dire. High inflation undermines wealth. If you put $100,000 under your mattress today, in ten years with high inflation, it will be worth a fraction of that amount.

Hyperinflation – when prices increase by 50% or more in a single month – is even worse. This essentially destroys a currency. A good that cost 10 dollars a week ago may now cost 150 dollars.

High inflation also creates uncertainty. Businesses are hesitant to invest when they do not know what money will be worth in six months. This surprise usually hinders economic growth.

The Dilemma of Government Control

Many free market advocates criticize government regulation of inflation. They say that the ability of governments to “create new money” undermines the natural principles of markets and encourages spending that is not sustainable. This criticism has some truth to it, but both sides of the discussion recognize that unchecked inflation is disastrous.

Overview

Inflation is a complex phenomenon that cannot be simply characterized as good or bad. A low, predictable inflation is a hallmark of healthy modern economies. It encourages spending, investment, and banking activity. But when it gets out of control, it can cause serious harm.

The solution is a flexible government policy – monetary and fiscal – that can be adjusted when conditions change. If these policies are implemented carefully, they can keep inflation at a level that benefits the overall economy without causing harm.