Definition and Economic Impact of Inflation: From Principles to Responses

What is Inflation? Definition Analysis of Inflation

Inflation, simply put, means that your money is becoming less and less valuable. The core definition of this concept is: a phenomenon of the decline in currency purchasing power, manifested by the continuous rise in the prices of goods and services.

Unlike short-term price fluctuations, true Inflation is a long-term phenomenon—price increases must be sustainable, not a flash in the pan. Almost all countries regularly calculate the inflation rate, usually on an annual basis.

Your grandmother says that things used to be much cheaper, and this is precisely the effect of Inflation. The price of a meal decades ago is completely different from today, and this long-term price change is the best illustration of Inflation.

How Does Inflation Occur? Three Main Mechanisms

Demand-pull Inflation

This is the most common type of Inflation, occurring when demand exceeds supply. Imagine a scenario: the economic situation improves, and people have more money to spend. Suddenly, everyone wants to buy something—maybe a house, a car, or any hot commodity.

The sellers are facing a problem at this time: supply cannot keep up. Although they can expand production, it takes time. During this waiting period, competition is fierce, and some buyers are willing to pay a higher price to obtain the goods. The result is a price increase. When this situation spreads throughout the economy, you see demand-driven Inflation.

Cost-Push Inflation

This type of Inflation comes from rising production costs. For example, a surge in crude oil prices, shortages of raw materials, or the government raising the minimum wage.

Sellers face a choice: either absorb these additional costs (which erode profits) or pass the costs onto consumers. In most cases, they choose the latter. Even if demand does not increase, the prices of goods will rise. This is why supply chain crises often lead to Inflation.

Endogenous Inflation

This is the most cunning type. It stems from the inflation expectations that already exist in the economy. When people expect prices to rise, their behavior changes:

• Employees demand higher wages to offset the expected decline in purchasing power
• Companies raise prices to protect profits
• This has led workers to demand higher wages… forming a vicious cycle.

This wage-price spiral can be self-reinforcing, allowing Inflation to persist.

How does the government combat Inflation?

Increase interest rates

The most commonly used tool by central banks is to raise interest rates. When borrowing becomes expensive, the desire of people and businesses to take out loans decreases, leading to a reduction in consumption and investment. With lower demand, the pressure on prices to rise is alleviated.

But there is a cost: economic growth may slow down as businesses and individuals become more cautious under high interest rates.

Adjust government spending and taxation

This falls under the category of fiscal policy. The government can increase taxes or decrease spending, reducing the cash in the hands of consumers and businesses. With a decline in demand, inflation will also ease.

However, the public generally does not welcome tax increases, which is politically sensitive.

How to Measure Inflation? The Role of the Consumer Price Index

The standard tool for measuring Inflation is the Consumer Price Index (CPI). It tracks the price changes of a basket of goods and services over time, reflecting the real purchasing power of the average household.

For example: If the CPI in the base year is 100, and it rises to 110 two years later, that means prices have increased by 10%.

Regular monitoring of this index helps policymakers determine whether action needs to be taken.

The Duality of Inflation: Pros and Cons

Why moderate Inflation is actually not bad

1. Stimulate consumption and investment: Moderate inflation encourages people to spend money now rather than saving it. This boosts economic activity.

2. Corporate Profit Margin: Companies can raise prices to protect profits and may even benefit from it.

3. Better than Deflation: Deflation (price decrease) sounds good, but it is actually very dangerous. Falling prices make consumers inclined to delay purchases, waiting for cheaper goods. This leads to a collapse in demand and rising unemployment rates. Historical periods of deflation are often accompanied by economic recessions.

The dangers of uncontrolled Inflation

1. Wealth Erosion: The 1 million you save today may only be worth 500,000 in ten years. Savings have turned into a losing business.

2. Hyperinflation: When the monthly price increase exceeds 50%, it enters the hyperinflation zone. The economy falls into chaos, and the currency almost loses its value. The prices of ordinary goods become ridiculous.

3. Economic Uncertainty: High Inflation rates leave people unsure about the future, making them more cautious, leading to reduced investment and consumption, and slowing economic growth.

4. Political Dissent: Some people oppose the government's intervention in the economy, believing that the free market should regulate itself.

Summary: Finding the Optimal Solution in Balance

Inflation is like any economic phenomenon — extremes are not acceptable, balance is key. Moderate inflation (usually 2-3%) is beneficial for the economy, but uncontrolled inflation can lead to disaster.

In the modern economy, the definition and management of Inflation has become a core responsibility of central banks. By flexibly using interest rate policies and fiscal tools, the government attempts to maintain price stability – neither rising too quickly nor experiencing deflation.

The key is to recognize that inflation is not an either-or enemy, but an economic force that needs to be carefully managed. This is especially important in the era of cryptocurrencies, as many investors are turning to digital assets as a hedge against inflation.