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What is Inflation?

What is inflation? What causes it? And is its common definition actually misleading? Let’s take a closer look.

What is inflation?

In basic terms, inflation is the rate at which goods and services go up in price. If the supply of money is increasing, then the value of the currency is decreasing. There are two basic causes of inflation:

1. A sudden increase in the supply of actual currency in circulation.

2. A shortage of specific goods or services that are in demand. This can cause a general rise in prices for those goods or services.

There are two main technical terms to describe these types of inflation:

1. Demand-Pull is the most common type of inflation and is caused by increased spending. In this case, demand outweighs the supply, causing prices to rise.

2. Cost-push occurs when prices rise due to an increase in production or material costs, shortages in resources or increases in taxation on goods. Those costs are “pushed” to the consumer.

How do governments respond to inflation?

Governments and central banks attempt to limit the impact of inflation by altering the money supply and changing fiscal and monetary policy. Central banks can alter the supply of fiat money by increasing or decreasing the amount in circulation. In practice, central banks typically raise interest rates to control inflation. This makes it more expensive to borrow money, and credit becomes less attractive to individuals and businesses, causing the demand for goods and services to fall.

Fiscal policy refers to the governments’ control of taxes to influence the economy. If a government increases the amount of income tax they collect, individuals will have less disposable income, reducing market demand.

How is it measured?

In many countries, a Consumer Price Index is used to measure inflation. A CPI considers the prices of a range of consumer products and compares them to historical prices. But is there more to it?

The idea that inflation=CPI is arguably too simple. At its core, inflation is the rate at which the things you want to buy are going up in price. But this depends on what you want to buy.

What are the things you want to buy? Luxury or essential goods? Food? Netflix? Jewellery? A house? A rare piece of art? Stocks?

The rate of inflation or the rate in the change of price will differ depending on what it is you want to buy. It will differ depending on the time period too. After lockdown, for example, houses in the countryside typically went up in price- which is not surprising since cafes, cinemas, restaurants, and offices were closed, there was no need to remain in the city. Human behaviour causes people to take their money and buy the things they want.

Calculating inflation requires taking into consideration a basket of goods, services and assets that you would want to buy. This basket will be different for every person, every place, and every time period. When we look deeper, the equation: inflation=CPI starts to seem like a significant oversimplification, doesn’t it?

Disclaimer: THIS IS NOT FINANCIAL NOR INVESTMENT ADVICE. Only you are responsible for any capital-related decisions you make, and only you are accountable for the results.

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