Understanding Inflation

While it is easy to measure the price changes of individual products over time, human needs extend beyond one or two such products. Individuals need a big and diversified set of products as well as a host of services for living a comfortable life. They include commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like healthcare, entertainment, and labor.

Inflation is the decrease in the purchasing power of a currency. That is, when the general level of prices rises, each monetary unit can buy fewer goods and services in aggregate. The impact of inflation differs on different sectors of the economy, with some sectors being adversely impacted while others benefitting.

For example, with inflation, those segments in society which own physical assets, such as property, stock, etc., benefit from the price/value of their holdings going up, when those who seek to acquire them will need to pay more for them. Their ability to do so will depend on the degree to which their income is fixed. For example, increases in payments to workers and pensioners often lag behind inflation, and for some people, income is fixed.

Also, individuals or institutions with cash assets will experience a decline in the purchasing power of cash. Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature.

How Does Inflation Work?

Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In 1980, for example, a movie ticket cost on average $2.89. By 2019, the average price of a movie ticket had risen to $9.16. If you saved a $10 bill from 1980, it would buy two fewer movie tickets in 2019 than it would have nearly four decades earlier.

Don’t think of inflation in terms of higher prices for just one item or service, however. Inflation refers to the broad increase in prices across a sector or an industry, like the automotive or energy business—and ultimately a country’s entire economy.

The chief measures of U.S. inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the whole American economy.

What Causes Inflation?

The gradually rising prices associated with inflation can be caused in two main ways: demand-pull inflation and cost-push inflation. Both come back to the fundamental economic principles of supply and demand.

Demand-Pull Inflation

Demand-pull inflation is when demand for goods or services increases but supply remains the same, pulling up prices. Demand-pull inflation can be caused in a few ways. In a healthy economy, people and companies increasingly make more money. 

Cost-Push Inflation

Cost-push inflation is when the supply of goods or services is limited in some way but demand remains the same, pushing up prices. Usually, some sort of external event, like a natural disaster, hinders companies’ abilities to produce enough of certain goods to keep up with consumer demand. This allows them to raise prices, resulting in inflation.

HOW TO CONTROL IT?

Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general, the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon the unprofitable economic activity.

The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed.

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