What is inflation? Many people are looking for meaning and definition to rising prices, but do you know what the causes are and how to combat it? In this guide, we learn about the different types of inflation, how to measure it, how this affects the exchange rate you can see on rates.fm, and some solutions to the loss of value of money.
What is Inflation?
Inflation is an increase in the general level of prices in the country over a certain period of time, which is accompanied by a devaluation of the national currency. Often compared to the US dollar, the exchange rate of which you can look at Rates. In other words, prices for food, clothing, rent, etc. are rising. At the same time, the prices of different goods may increase at different rates.
The increase in the general level of prices, or inflation, is measured using price indexes. One or another price index characterizes the level of inflation. Which shows how prices have changed in the national economy over a certain period. Economists also calculate the rate of inflation, which shows whether inflation has accelerated or slowed down over a certain period. The inflation rate is determined by the formula:
Inflation rate = Pt – Pt-1 / Pt-1 x 100%,
where: Pt is the price level in the current period; Pt-1 is the price level in the previous period.
Types of Inflation
Depending on the level, three types of inflation are distinguished.
- Moderate inflation occurs when prices rise slowly, up to 10% per year. With such inflation, prices are relatively stable. During this period people willingly save money, because their value does not depreciate much. Basically, savings are kept on bank cards, and as you know, Visa cards are accepted by 150 countries, so this is convenient. Moderate inflation, at which prices rise up to 5% per year, is called creeping.
- Galloping inflation is when prices rise by 20, 50, 100, or more percent per year. Money loses its value very quickly, so the population hardly saves money in the form of cash. People want to buy goods with their money. For example, the USA experienced such inflation that it reached 31% in 1778 during the Revolutionary War.
- Hyperinflation occurs when prices begin to rise by thousands, tens of thousands, or even millions of percent per year. Everyone wants to stockpile and get rid of money. Businesses buy investment goods, and the public uses savings and current income to buy consumer goods until money is finally devalued. There is an “inflationary psychosis”, which increases the pressure on prices. Hyperinflation means economic and social chaos, financial collapse, and socio-political disorder. Hyperinflation also occurred in Ukraine in 1993.
What Causes Inflation?
Inflation is a general and long-term rise in prices. Therefore, a one-time price increase cannot be characterized as inflation. Inflation leads to loss of purchasing power of money.
There are three main causes of inflation:
- Demand-driven inflation: If demand increases faster than the supply of goods, prices rise (shortage effect). This could be the result of creating too much money, population growth, or a catch-up effect after a crisis ;
- Cost Inflation: Increases in costs faced by businesses affect the prices of goods and services, which in turn rise. This can be an increase in either imported products (known as imported inflation) or in production costs;
- Inflation by money: Inflation here is caused by the excessive creation of money, more precisely by the too-high growth of the money supply in relation to the growth of production.
What are the Effects of Inflation?
Too high inflation can have negative consequences for the economy. Indeed, this creates a deterioration in the price competitiveness of products produced in the territory in comparison with those designed abroad. The result is a decline in the activity of domestic companies, which can lead to a reduction in the number of people and, accordingly, an increase in unemployment.
On the other hand, high inflation creates uncertainty about the future level of prices. Then companies are cautious about investments, profitability is difficult to predict. Excessive inflation also punishes households that suffer from a loss of purchasing power. Therefore, the latter may have to reduce their consumption to maintain their current standard of living.
When does Moderate Inflation have a Positive Effect on the Economy?
However, inflation is not always considered harmful. This is often seen in developing countries, where demand for goods is growing faster than supply as a result of rising purchasing power. In addition, by lowering the cost of debt, it encourages borrowing, which can provide a long-term boost to the economy if the borrowing is used for investment.
However, in general, inflation negatively affects the purchasing power of households and growth potential. If prices rise faster than wages, this reduces the amount of goods and services a household can buy. Inflation can also cut the competitiveness of the economy and foreign trade (in conditions of internal inflation, imported products become cheaper than domestic ones, and exported products find fewer buyers). Also, inflation cuts savings, causing a loss of value of the sums saved and reducing the rate of return. All these effects are likely to lead to lower economic activity, lower investment, and, therefore, growth potential.
What are the Means of Combating Inflation?
If inflation has a monetary origin, then monetary policy is the ideal lever for limiting the money supply through increasing interest rates and/or reserve requirements. This slows down economic activity. If the increase in demand is followed by inflation, the government can reduce distributed revenues (surcharges, public works programs) or limit the salary increases of public employees.
In addition, the increase in the ability of firms to increase supply helps to eliminate the imbalance between demand and supply. Both levers can have the side effect of causing a recession. That is why more structural actions are often preferred: the development of competition in markets, increasing the competitiveness of companies, better regulation of merger practices, etc.
As a result of efforts to conserve resources, inflation has increased across a variety of industries. From the perspective of the average person or business owner, the entire process seems incredible because it affects both the budget and the overall investments. In addition to its volatility, the world of finance is also highly diverse. Pay attention to the main currents and time your financial decisions well by following our advice in its most important aspects.