What Is Inflation? (And How to Control It)

Last updated on September 1, 2023

➤ What Is Inflation?

Inflation means prices going up.

This makes your money not go as far as before. It’s like when you could buy more with a certain amount of money, but now you can’t.

We can figure out how much prices are going up by looking at the average increase in the cost of things like food, clothes, and services over time.

This increase is usually shown as a percentage. When prices go up, the money you have can’t buy as much as it used to.

Inflation is different from deflation, which is when prices go down and your money can buy more.

➤ What Is the Meaning of Inflation?

Inflation isn’t just about one or two things getting more expensive. It’s about everything we need to live comfortably, like food, fuel, electricity, healthcare, and more.

When these things get more expensive over time, it’s called inflation. Inflation helps us see how much the overall cost of living is going up.

When prices go up, the money we have can’t buy as much as before. This makes life more expensive for everyone, and it can slow down how much the economy grows. Economists generally agree that if a country’s money supply grows faster than its economy, there can be a lot of inflation.

For example, in July 2023, the prices of things that people usually buy went up by about 0.2%. Over the year leading up to July, the cost of living went up by around 3.2%.

Remember, inflation is when the stuff we need gets more expensive, and that can affect how we live and how the economy works.

➤ How Do We Fight Inflation?

To tackle inflation, the group in charge of money (often the central bank) takes important steps to control how much money is around and how much people can borrow. This helps to keep inflation from getting too high and keeps the economy running smoothly.

A popular idea called “monetarism” helps explain how inflation and money are linked in an economy.

For example, when the Spanish took over the Aztec and Inca empires, they got a ton of gold and silver. This made the amount of money go up a lot, which caused the value of money to drop and prices to go up quickly.

Inflation gets measured in different ways based on what things are getting more expensive. The opposite of inflation is “deflation,” which is when things get cheaper because the inflation rate goes below 0%.

Just remember, deflation is different from “disinflation,” which is when the inflation rate is still positive, but it’s slowing down.

➤ What Causes Inflation?

Why does inflation happen? Well, the main reason is that there’s more money around. But this can happen in different ways. Here’s how:

1. Printing More Money: When a country’s leaders make more money and give it to people.
2. Making Money Worth Less: When they officially make the money you have worth less.
3. Creating Money Through Banks: When the leaders work with banks to make new money by buying government bonds. This is the most common way.

No matter how it’s done, having more money around makes money lose its power to buy things. This leads to three types of inflation: demand-pull inflation, cost-push inflation, and built-in inflation.

What Is the Demand-Pull Effect?

Ever wondered why things get more expensive? One reason is the “demand-pull” effect. Here’s what happens:

1. More Money and Credit: When there’s extra money and people can borrow more.
2. People Buy More: People feel good about money, so they buy more stuff.
3. Prices Go Up: Because everyone’s buying, there’s not enough stuff for everyone. So, the prices go up.

Imagine you and your friends all want the same toy, but there’s only one. You might offer more and more money to get it. That’s like what happens with prices. When there’s a lot of demand (people wanting to buy) and not a lot of supply (stuff to sell), prices go higher. That’s the “demand-pull” effect!

What’s the Cost-Push Effect?

Ever heard of “cost-push” effect? It’s when prices go up because making things costs more. Here’s how it happens:

1. More Money, More Costs: When there’s extra money and it goes into making things.
2. Things Get Expensive: The stuff needed to make things, like materials and resources, gets pricier.
3. Prices Rise: Since it costs more to make stuff, the final products or services also cost more.

Imagine you’re baking cookies, but suddenly the price of flour and chocolate chips goes up. That means making cookies costs more, so you might have to charge more for them. This is like the “cost-push” effect. When making stuff becomes pricier, the things you buy also get pricier.

What’s Built-In Inflation?

Ever heard of “built-in” inflation? It’s when the idea of prices going up gets stuck in people’s minds. Here’s how it works:

1. Expecting More Price Increases: When people think prices will keep going up.
2. Wanting More Money: If people believe things will cost more, they might ask for higher wages.
3. Higher Costs Everywhere: When wages go up, companies need more money to pay workers. So, they might raise prices on their products.
4. Cycle of Increases: This keeps happening in a circle – higher wages lead to higher prices, and then people want even higher wages, and so on.

Imagine if your allowance went up, but the cost of your favorite snacks also went up. You might ask for even more allowance. This can happen with salaries and the prices of things. It’s like a loop that keeps pushing prices higher.

➤ How to Measure Prices

We use different ways to check how prices change. We look at sets of things we buy to see how much they cost over time. Here are the main ways we do it:

1. Consumer Price Index (CPI): This looks at what regular people like us buy. It helps see if the stuff we usually get is getting more expensive.
2. Wholesale Price Index (WPI): This checks the prices of things before they reach the store. It’s like looking at the cost of things for the stores.

By checking these indexes, we can tell if things are getting pricier for everyone.

What’s the Consumer Price Index (CPI)?

The CPI helps us see how prices change for things we really need. These things include transportation, food, and medical care.

To figure out the CPI, we look at the prices of specific items in a group of stuff people usually buy. We find the average change in prices for these things and see which ones matter more. Then we put all the changes together to get an overall picture.

This helps us see how the cost of living is changing, which is really useful to know if things are getting more expensive or cheaper. In the U.S., experts at the Bureau of Labor Statistics (BLS) tell us about the CPI each month, and they’ve been doing it since 1913.

By the way, the CPI-U, introduced in 1978, shows what about 88% of people in the U.S. usually buy. It’s like looking at the shopping habits of most folks.

What’s the Wholesale Price Index (WPI)?

The WPI helps us see how prices are changing even before things reach the store. It’s like a sneak peek at the prices before they get to us.

When we look at the WPI, we’re checking the prices of things before they become final products. These things are usually at the producer or wholesale level.

Imagine you’re baking cookies, and you want to know how much the flour and chocolate chips cost before you buy them. That’s what the WPI does.

Different countries have different things in their WPI. For example, it might include prices for things like raw cotton, cotton yarn, and other stages of cotton stuff. Some countries, like the U.S., have their own version called the producer price index (PPI), which is pretty similar to the WPI.

What’s the Producer Price Index (PPI)?

The PPI is like a family of numbers that show how much money producers get for the things they make. These things could be stuff that’s not final yet, like materials or services.

When we look at the PPI, we’re seeing how much money the makers are getting for their stuff over time. This is different from the CPI, which shows how much buyers pay for things.

Different versions of the PPI look at different groups of things. Sometimes, if one thing gets more expensive (like oil), and another thing gets cheaper (like wheat), the effects balance out a bit.

So, each PPI number is like an average of how prices change for certain things. This can apply to the whole economy, certain sectors, or specific things.

➤ How to Calculate Inflation Simply

Want to figure out how prices have changed over time? It’s not as hard as you might think. You can use some simple math to get the answer. Here’s how:

1. Percent Inflation Rate: You want to know how much prices went up. To do this, you take the final CPI (Consumer Price Index) number and divide it by the initial CPI number. Then you multiply by 100 to get a percentage.
2. Example Calculation: Let’s say you’re curious about the value of $10,000 from September 1975 to September 2018. Look up the CPI numbers for those months (54.6 for 1975 and 252.439 for 2018).
3. Using the Formula: Plug the numbers into the formula: (252.439 ÷ 54.6) x 100 = 462.34%. This means prices went up by 462.34%.
4. Calculating Changed Value: Now, to see how much $10,000 changed, you multiply it by the inflation rate: 4.6234 x $10,000 = $46,234.25.

In simple terms, this means that if you spent $10,000 on things in 1975, the same things would cost you about $46,234.25 in 2018. That’s how inflation works – prices go up over time.

➤ What are the Pros and Cons of Inflation?

Is inflation good or bad? It depends on how you look at it and how fast it’s happening. Here are the upsides and downsides:

Pros of Inflation:

1. Assets Get Pricier: If you own things like property or stuff that gets more expensive with inflation, you might be happy. When their price goes up, you can sell them for more.
2. Encourages Investment: Inflation makes some businesses and people take risks for better returns. This can boost the economy.
3. Spending Boost: A bit of inflation can make people spend more now than later. This helps the economy grow.

Cons of Inflation:

1. Higher Costs: If you’re buying things, prices going up means you need to spend more. It’s bad for your wallet.
2. Uncertainty: Businesses and people get unsure about future prices. This can lead to confusion and wrong decisions.
3. Economic Problems: Too much inflation can mess up an economy. It makes planning and saving tough.
4. Distorted Prices: When prices rise at different rates, it messes up how things should cost. This can hurt the economy.

So, even though some inflation can be good, too much or too fast can lead to problems. It’s a balance between helping the economy and causing confusion.

➤ How to Control Inflation

A country’s money manager has an important job – keeping inflation from getting out of hand. They do this by using a set of actions called “monetary policy.” This policy is decided by a central bank or other groups that handle the country’s money.

In the U.S., the goal of the central bank (known as the Fed) is to keep things stable. They want prices to rise slowly and steadily, make sure interest rates are okay, and help as many people find jobs as possible.

When prices stay pretty steady, businesses can make plans for the future. The Fed wants this because it helps create jobs too. They don’t set a fixed goal for how many jobs, but they try to help as many people as they can.

Sometimes, when things get really tough, the central bank takes special steps. Like during the 2008 financial crisis, the U.S. Fed kept interest rates super low and bought bonds to help the economy.

People worried these moves might make prices spike, but that didn’t happen. Actually, inflation went down. There are many reasons why, but a big one was that the crisis itself made prices go down.

Other countries also use these tricks. For example, the European Central Bank (ECB) did this to stop prices from going down too much in the eurozone. Some places even had negative interest rates to keep prices from falling.

Different countries aim for different levels of inflation. For example, India wants around 4% inflation, and Brazil aims for about 3.25%. It’s like a balancing act – not too much, not too little.

➤ How to Hedge Against Inflation

Worried about prices going up? There are ways to keep your investments safe. Here’s how:

1. Stocks Are Good: When prices rise, stock prices (usually) do too. This makes stocks a good way to fight inflation.
2. Smart Investments: Special tools exist to guard your money from inflation. One is called Treasury Inflation-Protected Securities (TIPS). These are like safe investments that grow as inflation does.
3. More Options: You can also try TIPS mutual funds or TIPS-based exchange-traded funds (ETFs). These are ways to invest in lots of TIPS together.
4. Brokerage Account: To invest in stocks, ETFs, and funds, you need a brokerage account. But picking the right broker can be a bit tricky.
5. Golden Option: Gold is another way to fight inflation. It’s seen as a safe option, even though history doesn’t always show this.

So, if you’re worried about your money losing value, consider these ways to keep it safe from rising prices.

➤ Inflation Gone Wrong (Examples)

Sometimes, money can lose value really quickly, and this leads to super high prices. Here are some crazy examples:

1. German Hyperinflation: In the 1920s, Germany’s money lost its worth quickly. After World War I, Germany owed money to other countries. They tried printing more money to pay back, but this made money less valuable. People started spending money fast before it became even less valuable. The German mark lost its value so much that people used money as wallpaper!
2. Peru and Zimbabwe: Similar things happened in Peru in 1990 and Zimbabwe between 2007 and 2008. Money lost value like crazy, and prices shot up.

These are extreme cases where money became almost useless due to too much printing. It’s a big lesson on how important it is to manage money wisely!

➤ Inflation FAQ

What Creates Inflation?

Inflation happens because of three main reasons: demand-pull inflation, cost-push inflation, and built-in inflation.

• Demand-Pull Inflation: When there’s not enough stuff to buy compared to what people want, prices go up.
• Cost-Push Inflation: If it costs more to make things, businesses raise prices to cover their expenses.
• Built-In Inflation: When people ask for more money to keep up with higher living costs, it makes businesses raise prices. This can keep happening in a loop.

Is Inflation Good or Bad?

Too much inflation is bad for the economy, and so is too little. Most experts agree that a little inflation, around 2% each year, is good.

• Good for Borrowers: Some people benefit from inflation because the value of their debts gets smaller.
• Bad for Savers: But for those who save money, inflation can make their savings buy less over time.

What Are the Effects of Inflation?

Inflation changes things in the economy. It can make some goods cheaper to other countries, but also make imported stuff pricier. People might buy things faster because prices are going up. But if you save money, it could lose value, which might affect your future spending and investing.

Why Is Inflation So High Right Now?

In 2022, prices went up a lot in the U.S. and worldwide. This happened because of a mix of reasons:

• COVID-19 Impact: The pandemic messed up supply chains, making it hard to get things.
• Government Help: Governments gave money to people and businesses to cope with the pandemic, and this extra money led to more spending.
• Supply Struggles: As the economy recovered, more people wanted things, but supplies were still low.
• Global Issues: Stuff like Russia’s actions in Ukraine and food harvests also made prices go up.

All these things together pushed prices up by a lot.

➤ Final thoughts

Inflation means prices going up, which makes your money buy less. A little rise in prices, around 2%, is okay – it’s natural. But if prices shoot up too quickly, it’s a problem.

Inflation makes things cost more. If your pay doesn’t go up as much, you’re in trouble. And even your money’s value drops – especially cash.

Governments and banks work to keep inflation in check. They use money tricks to manage it, so things don’t get too expensive too fast.

➤ References

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