Understanding inflation: definition and economic mechanisms

Why did your parents pay less in the past? A question many ask. The answer lies in a fundamental economic phenomenon: inflation. It is the gradual reduction of the purchasing power of a currency, manifested by the sustained increase in prices of goods and services in a given economy.

Unlike a simple variation in relative prices that would only concern one or two items, inflation extends to almost all economic sectors and persists over the long term. It is a measurable process tracked annually by most governments through specific indices.

The three engines of inflation

When demand exceeds supply

Demand-pull inflation represents the most common type. It occurs when consumers have more resources to spend. Imagine a market where the demand for products suddenly accelerates due to better economic conditions. Producers, already operating at full capacity, can only increase their production gradually. Faced with this relative scarcity, prices naturally rise. Multiplying this phenomenon across all sectors creates widespread inflation.

When production costs increase

Cost-push inflation works differently. It occurs when production expenses rise – increase in raw materials, minimum wage hikes, or increased government taxes. Producers, forced to absorb these extra costs, pass the increase on to the selling price, regardless of the actual demand from consumers.

A change in the exchange rate can also play this role: a weak currency makes imports more expensive, which increases domestic prices.

The memory effect: embedded inflation

Built-in inflation, sometimes referred to as “hangover inflation,” results from previous inflationary periods. It occurs when workers and employers anticipate a continuation of inflation: employees demand higher wages to preserve their purchasing power, forcing companies to raise their prices.

This phenomenon creates a self-reinforcing price-wage spiral, where each increase in costs prompts a new demand for wage increases, thereby perpetuating the inflationary cycle.

How to control inflation?

Governments and central banks have several levers to keep inflation at a healthy level.

The increase in interest rates remains the most commonly used method. By making borrowing more expensive, it reduces spending by consumers and businesses, thereby decreasing overall demand. Saving becomes more attractive, which moderates the money supply.

Fiscal policy offers an alternative. Governments can increase taxes or reduce public spending to decrease the available purchasing power and curb demand. However, this approach requires great caution, as it can provoke significant public opposition.

Measuring Inflation: The Price Index

To determine whether intervention is necessary, it is first essential to quantify inflation. The main tool is the consumer price index (CPI), which tracks the evolution of the cost of a standardized basket of goods and services purchased by households.

Organizations like the Bureau of Labor Statistics regularly collect this data from businesses to ensure accuracy. If the CPI rises from 100 in the base year to 110 two years later, prices have increased by an average of 10 %.

The Two Facets of Inflation

Moderate inflation is not necessarily negative. In contemporary fiat currency systems, slight inflation encourages consumption and investment: keeping money idle would be counterproductive as it would lose value. Businesses also benefit, justifying price and margin increases.

However, high inflation becomes destructive. It erodes the wealth of individuals: 100,000 euros saved today will have much less purchasing power in a decade. Hyperinflation ( monthly increase above 50% ) is catastrophic, rendering currencies unusable and devastating economies.

High inflation also generates uncertainty. Individuals and businesses, hesitant in the face of an unclear economic future, reduce investments and spending, slowing down growth.

Conclusion: finding balance

Simple definition of inflation: the decrease in purchasing power due to the generalized increase in prices. However, understanding this complex phenomenon shows that not everything is black or white.

The issue lies in balance. Controlled inflation stimulates the economy and encourages the flow of capital. Runaway inflation destroys it. Therefore, governments must continuously adjust their monetary and fiscal policies to maintain this delicate balance – a permanent economic dance where too little or too much inflation causes certain damage.