How often do you go grocery shopping? Once a week? Every other week? It's probably a place you go to frequently; you've likely memorised your grocery list's prices. So much so that you likely will notice any increase in the price of your typical grocery bill! The increase in the price of goods is an important concept in economics that economists and the general population must understand. Continue reading to learn more about inflation!
Inflation Meaning
Let's go over inflation's meaning; we can start by defining the term. Inflation is the general increase in prices while value remains the same. Inflation can occur in certain products or industries, but it does not need to occur in every product or industry for it to be considered inflation. If the price of apples goes up from week 1 to week 2, then it's inflation!
When inflation occurs, the dollar's purchasing power is reduced. If your weekly grocery bill is $200 and there is inflation for all the products you normally buy, then the $200 you normally use for your grocery bill will not buy you the same number of goods you're used to. Therefore, you either buy fewer goods or pay more for your typical grocery list.
Depending on the rate of inflation, it can be more or less harmful to the economy. A small amount of inflation each year is desired, but inflation that rises or falls too quickly can cause other problems!
Inflation is the general increase in prices.
Purchasing Power is the real value of money expressed in how many goods and services it can purchase.
A Dollar Burning, pixabay
Example for inflation
Let's take a look at examples for inflation by looking at how it impacts:
Inflation Example: Consumers
As a consumer, prices are a vital component of purchasing products. How might an increase in prices affect the way consumers purchase products?
Consumers cannot purchase the same number of products if their income stays the same. For example, if your income stays the same and prices increase, then your purchasing power is reduced. Therefore, you are left with two difficult options: purchase the same number of goods at higher prices or purchase fewer goods because of higher prices. This decision can become very difficult when it comes to essentials like food, housing, and healthcare.
Figure 1. U.S. Consumer Price Index for May, StudySmarter Originals. Source: Bureau of Labor Statistics
The graph1 above shows the United States consumer price index (CPI) for the month of May year after year. As you can see, the CPI was hovering around 2% up to 2021 and 2022. The CPI grew at a rapid pace, indicating that the average market basket for consumer goods increased dramatically — inflation.
Inflation Example: Producers
As a producer, prices are a vital component of creating products for consumers. How might an increase in prices affect the way producers make products?
Producers will have to make decisions about their production if inflation occurs.
If a firm produces laptops and the price of inputs increases (microchips and screens), then a firm will have to make one of two decisions: increase the price of laptops for consumers to cover the price of inputs, or keep the price of laptops the same and decrease their revenues.
The rational choice for firms is to increase prices to cover their costs, but this would contribute to inflation. As you can see, firms have difficult decisions to make as well, just like consumers.
Inflation and Deflation
Inflation and Deflation are similar concepts but have clear distinctions. Inflation is the general increase in prices, whereas Deflation is the general decrease in prices. On the surface, deflation seems like a great thing, right? Imagine paying less than you were anticipating for your grocery bills, a car, or even a mortgage! However, deflation can also produce a deleterious outcome for consumers and producers alike.
When deflation occurs, the general prices are decreasing in the economy. If you know that your purchasing power will increase in the future, then you will save your money so that you can purchase more goods in the future. Why buy now if you can buy the same goods at a cheaper price later? This thought process is what makes deflation so dangerous. This will cause consumers to buy fewer products and producers to make fewer products, causing a slowdown in the economy and potentially a recession.
Deflation is the general decrease in prices.
Do not confuse deflation with disinflation, a decrease in the inflation level from the previous year.
Inflation Causes
Inflation causes can be grouped by inflation type:
- demand-pull,
- cost-push,
- and built-in.
Demand-Pull
Demand-pull inflation occurs when there is an increase in total spending that exceeds economic production. You may have heard the term, "Too many dollars chasing too few goods." In essence, this is what demand-pull inflation is. This can occur from a central bank printing too much money in the economy when there are not enough resources to produce goods. The extra money bids up the prices for the few goods in the economy, leading to inflation.
Demand-pull inflation occurs when there is an increase in total spending that exceeds economic production.
Cost-Push
Cost-push inflation occurs when there are supply shocks in the economy. If there is an overall decrease in supply in the economy, then firms will have to increase prices to make up for the shortage. The decrease in supply can happen for several reasons, such as rising input costs, a decrease in resources, and a shortage of available labor. Anything that may increase the cost of production could lead to a decrease in supply, which could then lead to an increase in prices.
Cost-push inflation occurs when there are supply shocks in the economy due to rising costs of factors of production.
Built-in
Built-in inflation occurs when workers recognize that their wages are not keeping up with inflation rates. Workers will demand higher wages from their employers to keep up with inflation. Workers' purchasing power will not decrease if there is a commensurate increase in wages with inflation. When this occurs, firms will increase their prices as a result of increased wages, causing the prices of goods to increase in the economy. This cycle will continue and cause inflation.
Built-in inflation occurs when workers ask for higher wages to keep up with inflation, and firms subsequently increase prices to cover the wage increases.
Inflation Types
Let's go over the three main inflation types: inflation, disinflation, and hyperinflation.
Inflation
Inflation is the general increase in prices. Generally, the central bank (The Fed in the U.S.) is targeting a small amount of inflation each year — around 2%. This indicates a healthy and growing economy since consumers are purchasing products and producers are making products. This, inevitably, will cause prices to rise by a small amount each year. However, when inflation spirals out of control, it can pose problems for the economy.
Hyperinflation
Hyperinflation is the rapid increase in prices, categorized as an increase of 50% or more. Hyperinflation is dangerous because of the amount of uncertainty it has on the economy. Consumers and producers are heavily impacted — consumers struggle to purchase any products, and producers struggle to sell any products. The dollar's purchasing power becomes nearly meaningless, as it can barely serve as a medium of exchange. This is a dangerous position for an economy to be in and difficult to recover from.
Gasoline prices often experience inflation, causing the price to increase from $3 to $3.50. However, if gas were to experience hyperinflation, it would increase from $3 to 6$ or even $20 a gallon.
Hyperinflation is the rapid increase in prices.
Disinflation
Disinflation is the decrease in the inflation rate. For example, if the United States experiences 2.5% inflation in 2022 and 2% inflation in 2023, disinflation occurred. The issue with disinflation is that it could be a precursor to deflation. If the inflation rate keeps declining year after year, it could continue until there is deflation in the economy. Deflation can have devastating effects on the economy; as such, disinflation should be monitored closely to preclude deflation.
Disinflation is the decrease in the inflation rate.
Inflation - Key takeaways
Inflation is the general increase in prices.
Deflation is the general decrease in prices.
The three causes of inflation are cost-push, demand-pull, and built-in.
Hyperinflation is the rapid increase in prices.
Disinflation is the decrease in the inflation rate.
References
- Bureau of Labor Statistics, U.S. Consumer Price Index for May, 2012-2022, https://data.bls.gov/timeseries/CUUR0000SA0L1E
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