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Everything you Need to Know About Inflation

By João Pires

Published on 26 March 2024

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What is Inflation?

Definition of Inflation 

Inflation refers to the sustained increase in the general price level of goods and services in an economy over a period of time. It is measured by calculating the percentage change in a price index, such as the Consumer Price Index (CPI), which tracks the average price of a basket of goods and services consumed by households. Inflation erodes the purchasing power of money, meaning that the same amount of money can buy fewer goods and services. This can have significant impacts on individuals, businesses, and the overall economy. 

Causes of Inflation 

Inflation can be caused by various factors, including increased demand for goods and services. When there is a surge in consumer spending, businesses may struggle to keep up with the demand, leading to price increases. Additionally, cost-push inflation can occur when the cost of production rises, such as an increase in wages or raw material prices. This can result in businesses passing on the higher costs to consumers through higher prices. 

Another factor that can contribute to inflation is monetary factors. When the money supply in an economy increases, it can lead to an excess of money chasing a limited supply of goods and services, driving up prices. Central banks such as the European Central Bank play a crucial role in managing the money supply to control inflation. 

External factors can also impact inflation. Changes in international trade, such as tariffs or fluctuations in exchange rates, can affect the prices of imported goods and services. Natural disasters or geopolitical events can disrupt supply chains and lead to price increases as well. 

Types of Inflation 

There are several types of inflation that can occur in an economy. Understanding these types can help individuals and policymakers make informed decisions. Here are some common types of inflation: 

  • **Demand-Pull Inflation:** This type of inflation occurs when there is an increase in aggregate demand, leading to higher prices. It is usually caused by factors such as increased consumer spending, government spending, or expansionary monetary policy. 
  • **Cost-Push Inflation:** Cost-push inflation happens when there is an increase in production costs, such as wages or raw material prices. This increase in costs is then passed on to consumers in the form of higher prices. 
  • **Built-In Inflation:** Built-in inflation refers to the expectation of future price increases. It occurs when workers and businesses anticipate inflation and negotiate higher wages and prices, leading to a self-perpetuating cycle of inflation. 
  • **Hyperinflation:** Hyperinflation is an extreme form of inflation characterized by rapidly increasing prices. It usually occurs when there is a loss of confidence in the currency and the government prints excessive amounts of money. 

Effects of Inflation

Impact on Purchasing Power 

Inflation has a significant impact on purchasing power, which is the amount of goods and services that can be purchased with a given amount of money. As the general price level rises, the value of money decreases, leading to a decrease in purchasing power. This means that individuals and businesses need to spend more money to buy the same amount of goods and services they could have purchased before. This decrease in purchasing power can erode the real value of savings and reduce the standard of living. 

To illustrate the impact of inflation on purchasing power, consider the following example: 

YearPrice of a Basket of GoodsInflation Rate
2010$100-
2020$12020%

In this example, the price of a basket of goods increased by 20% over a 10-year period. As a result, the purchasing power of $100 in 2010 decreased to $83.33 in 2020, assuming no change in income. This means that individuals would need to spend more money to maintain the same standard of living. 

It is important to note that the impact of inflation on purchasing power can vary depending on individual circumstances, such as income levels and spending patterns. However, in general, inflation reduces the purchasing power of money and can have a significant impact on individuals, businesses, and the overall economy. 

Effects on Investments 

When it comes to investments, inflation can have both positive and negative effects. On one hand, inflation can increase the value of certain investments, such as real estate or commodities, as their prices tend to rise with inflation. This can provide opportunities for investors to earn higher returns. On the other hand, inflation erodes the purchasing power of money over time, which can negatively impact the returns of fixed-income investments like bonds. It's important for investors to carefully consider the effects of inflation when making investment decisions. 

Inflation can also affect the performance of stocks. While inflation can lead to higher corporate profits and increased stock prices, it can also increase the cost of production and reduce consumer spending, which can negatively impact company earnings. Investors should closely monitor the impact of inflation on different sectors and industries to make informed investment choices. 

Inflation and Interest Rates 

Inflation and interest rates are closely linked. When inflation rises, central banks often respond by increasing interest rates. This is done to curb inflation and maintain price stability. Higher interest rates make borrowing more expensive, which can reduce consumer spending and investment. On the other hand, lower interest rates can stimulate economic growth by encouraging borrowing and spending. It's important for individuals and businesses to understand the relationship between inflation and interest rates, as it can have a significant impact on their financial decisions. 

Here is a table summarizing the relationship between inflation and interest rates: 

InflationInterest Rates
HighHigh
LowLow

As the table shows, when inflation is high, interest rates tend to be high as well. Conversely, when inflation is low, interest rates are typically low. This table can serve as a helpful reference when considering the impact of inflation on interest rates. 

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Measuring Inflation

Consumer Price Index (CPI) 

The Consumer Price Index (CPI) is a commonly used measure of inflation. It tracks the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI is calculated by comparing the current prices of the basket of goods and services to their prices in a base period. This index is widely used by policymakers, economists, and investors to monitor inflation trends and make informed decisions. 

The CPI provides valuable insights into the cost of living and the purchasing power of consumers. It helps individuals and businesses understand how inflation affects their budgets and financial planning. By tracking changes in the CPI, policymakers can assess the impact of their monetary and fiscal policies on the economy and make necessary adjustments. 

To interpret the CPI data, it is important to consider the components of the index. The CPI is composed of various categories, such as housing, transportation, food, and healthcare. Each category has a different weight in the index, reflecting its importance in the average consumer's budget. Changes in the prices of these categories can have different effects on the overall CPI. 

It is worth noting that the CPI is not a perfect measure of inflation. It has some limitations, such as the exclusion of certain items like investments and taxes. Additionally, the CPI may not accurately reflect the inflation experienced by specific individuals or groups, as it is based on average consumer spending patterns. However, despite these limitations, the CPI remains a valuable tool for understanding and monitoring inflation. 

Producer Price Index (PPI) 

The Producer Price Index (PPI) is an economic indicator that measures the average change in prices received by domestic producers for their output. It provides valuable insights into inflationary pressures at the producer level. The PPI is calculated by collecting data on prices from a sample of producers and weighting them based on their contribution to the overall economy. 

The PPI is divided into three main categories: finished goods, intermediate goods, and crude goods. Finished goods include products that are ready for sale to consumers, while intermediate goods are used in the production of finished goods. Crude goods are raw materials that are used in the production of intermediate goods. 

The PPI is often used as a leading indicator of inflation, as changes in producer prices can eventually impact consumer prices. It is closely monitored by policymakers, economists, and investors to assess the state of the economy and make informed decisions. 

GDP Deflator 

The GDP deflator is a measure of inflation that reflects the changes in prices of all domestically produced goods and services in an economy. It is used to adjust the nominal GDP for inflation, providing a more accurate picture of real economic growth. 

Unlike other inflation measures like the Consumer Price Index (CPI) and the Producer Price Index (PPI), which focus on specific sectors or categories of goods, the GDP deflator considers the entire economy. This makes it a comprehensive measure of inflation. 

The GDP deflator is calculated by dividing the nominal GDP by the real GDP and multiplying by 100. It is expressed as a percentage. 

Here is an example of how the GDP deflator is calculated: 

YearNominal GDPReal GDPGDP Deflator
2019$10,000$9,000111.11%
2020$11,000$9,500115.79%

The GDP deflator is an important tool for policymakers and economists to monitor inflation and make informed decisions regarding monetary and fiscal policies. 

Managing Inflation

Monetary Policy 

Monetary policy refers to the actions taken by a central bank to manage the money supply and interest rates in an economy. The goal of monetary policy is to promote price stability and economic growth. Central banks use various tools, such as adjusting interest rates, buying or selling government securities, and setting reserve requirements, to influence the availability and cost of credit. By controlling the money supply, central banks can impact inflation rates and overall economic activity. 

One important tool used in monetary policy is open market operations, where the central bank buys or sells government securities in the open market. This affects the amount of money in circulation and can influence interest rates. Another tool is reserve requirements, which determine the amount of funds that banks must hold in reserve. By adjusting these requirements, central banks can influence the amount of money that banks can lend. 

In addition to managing inflation, monetary policy also plays a role in stabilizing the economy during periods of recession or expansion. During a recession, central banks may lower interest rates and increase the money supply to stimulate borrowing and spending. Conversely, during an economic expansion, central banks may raise interest rates and reduce the money supply to prevent excessive inflation. 

Fiscal Policy 

Fiscal policy refers to the use of government spending and taxation to influence the economy. It is an important tool for managing inflation and promoting economic growth. Here are some key points to understand about fiscal policy: 
  • **Government Spending:** Fiscal policy involves the government's decisions on how much to spend on public goods and services. Increased government spending can stimulate economic activity and help combat deflation. 
  • **Taxation:** Fiscal policy also includes decisions on taxation. Changes in tax rates can affect consumer spending and business investment, which in turn can impact inflation. 
  • **Budget Deficits and Surpluses:** Fiscal policy can result in budget deficits (when government spending exceeds revenue) or budget surpluses (when revenue exceeds spending). These deficits or surpluses can have implications for inflation and the overall health of the economy. 
  • **Government Debt:** Fiscal policy can also influence the level of government debt. High levels of debt can put upward pressure on inflation and limit the government's ability to respond to economic downturns. 

Supply-side Policies 

Supply-side policies are a set of economic measures aimed at increasing the productive capacity of an economy. These policies focus on improving the efficiency and competitiveness of businesses, which in turn can lead to increased output and economic growth. Some common supply-side policies include: 

  • **Deregulation:** Removing unnecessary regulations and barriers to entry can encourage entrepreneurship and innovation. 
  • **Tax cuts:** Lowering taxes on businesses can incentivize investment and expansion. 
  • **Investment in infrastructure:** Building and maintaining infrastructure can improve productivity and attract investment. 

Inflation and the Economy

Inflation and Unemployment 

Inflation and unemployment are closely related in the economy. When inflation is high, it can lead to an increase in unemployment rates. This is because high inflation erodes the purchasing power of consumers, leading to a decrease in demand for goods and services. As a result, businesses may need to cut costs, which can include reducing their workforce. On the other hand, when inflation is low, it can stimulate economic growth and reduce unemployment rates. This is because low inflation encourages consumer spending and business investment, leading to an increase in demand for labor. Therefore, policymakers often aim to strike a balance between inflation and unemployment to maintain a stable and healthy economy. 

Here are some key points to consider: 

  • High inflation can lead to an increase in unemployment rates. 
  • Low inflation can stimulate economic growth and reduce unemployment rates. 
  • Policymakers aim to strike a balance between inflation and unemployment for a stable economy. 

Inflation and Economic Growth 

Inflation and economic growth are closely intertwined. When inflation is low and stable, it can promote economic growth by encouraging consumer spending and business investment. However, high inflation can have detrimental effects on economic growth. It can erode the purchasing power of consumers, leading to a decrease in consumer spending. Additionally, high inflation can increase uncertainty and discourage long-term investments. Therefore, maintaining a balance between inflation and economic growth is crucial for a healthy economy. 

Inflation and Income Distribution 

Inflation can have significant effects on income distribution. When prices rise, individuals with fixed incomes, such as retirees or low-wage workers, may struggle to afford the same level of goods and services. On the other hand, individuals with higher incomes may be better able to absorb the increased costs. This can lead to a widening wealth gap and increased inequality. 

To illustrate the impact of inflation on income distribution, let's consider a hypothetical example. Suppose there are two individuals, one with a fixed income of $1,000 per month and another with a higher income of $5,000 per month. If inflation causes prices to increase by 10%, the individual with the fixed income will now need to spend $1,100 to maintain the same standard of living, while the individual with the higher income will need to spend $5,500. This means that the individual with the fixed income will experience a larger decrease in purchasing power compared to the individual with the higher income. 

It is important to note that the impact of inflation and deflation on income distribution can vary depending on factors such as government policies, social safety nets, and the overall economic conditions. Governments can implement measures to mitigate the negative effects of inflation on lower-income individuals, such as increasing social welfare programs or implementing progressive tax policies. However, it is crucial to monitor and address the potential consequences of inflation on income distribution to ensure a fair and equitable society. 
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Written by João Pires

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