In economics, inflation is considered as a sustained increase in the general price level of goods and services in an economy over a period of time.
Inflation is one of the most commonly used terms in economics, we often hear it on the news on television or newspaper, this is because it is a very influential factor in economics, and therefore it is constantly monitored by central banks and monetary authorities.
After all, they try to keep it in a certain range, a range of values where it is considered to be beneficial and not harmful to the economy.
Inflation is a simple concept, as said in the introduction it is simply the general increase in the general price level of goods and services, this means that if you want to buy today a smartphone that is sold at $500, if you decide to wait one month and in the meantime inflation goes up 10%, at the end of the month, for the same product you will have to pay $550.
That was just an example, today in more developed economies the inflation level is a lot lower, around 2% per year, but however, is important to remember that it is not rare to see situations like that. For example, in Venezuela in 2018 inflation went so high as 1,698,488% (hyperinflation).
The problem with inflation and the reason why it is constantly monitored by institutions is that, when prices rise, each unit of currency (es. $1) buys fewer goods, therefore purchasing power per unit of money is reduced with inflation.
This means that assuming you have $1,000 in the bank today and one cup of coffee costs $1, you have a purchasing power of 1,000 coffees.
If, after an inflationary shock, coffee is sold at $2 per cup, your purchasing power will be halved. You will be able to buy 500 coffees with the total amount of money that you have in your bank account.
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How is it measured?
Inflation is measured by using the inflation rate, which is the annualized percentage change in a general price index (usually the consumer price index) over time.
This means that statisticians will track the price movements of a basket of goods and services purchased by households, which is considered representative of the general market.
Then, sub-indices and sub-sub-indices are computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the consumer expenditures covered by the index.
The index is usually computed monthly or quarterly, and the results of the previous month or quarter are compared with those of the actual month or quarter.
Even though different indexes are used depending on the phenomenon that we want to understand, the most commonly used inflation indexes are:
- The Consumer Price Index: examines the weighted average of prices of a basket of goods and services that are considered of primary consumer needs, like food, medical care, and transportation. The fact that it is a “weighted average” means that price changes are considered in the formula to calculate the CPI depending on their relative weight in the whole basket. The CPI is one of the most frequently used statistics because it used to assess price changes associated with the cost of living.
- The Wholesale Price Index: tracks and measures changes in the price of goods in the stages before the retail level, therefore they include items at the producer or wholesale level.
- The Producer Price Index: which is a group of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. It is similar to the CPI but differs from it because the PPI takes into consideration mainly price changes from the perspective of the seller, not of the buyer.
Is inflation good or bad?
To this question there is not a clear and definitive answer, inflation can be considered, for different reasons, both good and bad.
The fact that inflation is good or bad depends in which position one finds himself, in fact, for people that hold a large amount of their wealth in cash, an increase in inflation is negative, because, like in the examples above, if you have a net worth that can allow you to buy 1000 coffees and inflation rises by 10%, coffees will cost 10% more and therefore you will be able to buy a lot fewer coffees.
This happens because inflation erodes purchase power.
Anyway, the majority of economists agree on the fact that a certain (optimum) level of inflation can be helpful to promote spending instead of saving, therefore helping the economy to grow without damaging the wealth of individuals.
Moreover, is also important that there is no negative, uncertain or high value of inflation, in all those cases the effects of inflation are harmful to the economy.
They lead to an increase in uncertainties, which prevents businesses from making relevant investment decisions because they cannot guess where the economy is likely to go.
This is why central banks tend to have a specific value of inflation that they want to reach, which is disclosed to everybody in the economy. This creates a sense of certainty, which is a factor that helps the economy a lot.