What is Inflation? Definition and Complete Guide

What is inflation and what is its meaning? In summary, inflation is the rate at which prices of goods and services increase. But why do prices rise, what are the effects and what happens if inflation rises too much? How is inflation going in Europe?

The increase in the prices of goods and services over a period of time, i.e. inflation, has important consequences on the entire economy of the country, not only for the government, but also for citizens and businesses.

Inflation at a glance

• Inflation is a sustained increase in the general price level of goods and services.
• When inflation rises, there is a simultaneous decrease in the value of money (purchasing power).
• Variants of inflation include disinflation, deflation, hyperinflation, and stagflation.
• There is no common theory that explains the causes of inflation. Among the main causes we find the increase in demand, the increase in costs and monetary inflation deriving from the monetary policy of the reference central bank.
• When the rise in inflation is unexpected, creditors lose out together with bond investors, uncertainty reduces spending and exporters lose competitiveness.
• Lack of inflation (or deflation) is not necessarily a good thing and can lead to destabilizing deflationary spirals.
• Inflation is measured through a price index.
• There are two main types of price indices that measure inflation: the consumer price index (CPI) and the producer price index (PPI).
• Interest rates in the Eurozone are decided by the European Central Bank. Inflation plays an important role in the ECB’s interest rate decisions since each central bank has inflation targets to pursue and achieve.
• In the long run, the stock market and precious metals are a good hedge against inflation.

Inflation: Meaning and Definition

Inflation indicates a sustained increase in the general price level of goods and services in a country, and is measured as percentage change on a monthly or annual basis.

Inflation essentially indicates how much the euro (or any other currency) is worth at a given moment in terms of its purchasing power. The idea of inflation as a positive force for the economy lies in the fact that a sufficiently manageable rate of inflation can stimulate economic growth without devaluing the currency to the point of making it almost worthless.

Inflation can also vary from product to product. Depending on the time of year, the price of oil can go up regardless of the effect of inflation, which is often the case in the summer. For this reason there is a term - “core inflation” - to indicate inflation that affects the prices of all goods and services except food and energy (gas and oil), since these sectors have prices influenced by many other factors.

Types of inflation

There are several types of inflation.

• When the rate reaches double digits and ends up in the range between 10% and 20%, we speak of runaway inflation - much more worrying for citizens, as money is depreciating much faster than it should. Rising prices can have a devastating effect on the working class and low-end population, who are already in financial difficulty. Incomes don’t rise in tandem with prices and so people buy less, throwing the economy into chaos.

• Hyperinflation is the rarest but most disastrous case in an economy. A totally unmanageable increase of 50% or more in a short time can bring a country down. Recessions turn into depressions. People lose faith in flat money and start turning to safe-haven assets such as gold, leading to a significant reduction in commodity exchange. Financial institutions, with their liquid assets essentially worthless, fail. Hyperinflation is very rare, but it has made appearances in the past.

• There is also a form of inflation known as "stagflation", wherein inflation rates rise despite the fact that the economy is in a period of stagnation. This is generated in special circumstances, as happened in the United States in the 1970s, when despite high unemployment rates and negative economic growth, the price of oil skyrocketed.

• deflation occurs when the general price level is falling, with an effect opposite to that of inflation. It tends to occur more rarely and for shorter periods of time than inflation, often during times of recession or economic crisis, and can lead to very deep economic crises including depression. The causes belong to the effects of the so-called deflationary spiral: when prices fall, why spend your money today, when every euro you have in your pocket will be more valuable tomorrow?

• disinflation is a condition where inflation is still positive, but the inflation rate is falling - for example from +3% to +2%.

In some situations, low inflation can be as bad as high inflation. Lack of inflation can be a sign of a weak economy.
It’s not easy to define whether inflation is good or bad - it all depends on the health of the economy and your personal circumstances.

The causes of inflation

There is no single theory that explains the causes of inflation universally agreed upon by economists and academics, but there are some more accredited approaches.

Increase in demand
Inflation is caused by a global increase in demand for goods and services, which drives up prices. If demand grows faster than supply, prices rise. This usually occurs in fast growing economies. This theory is often promoted by the Keynesian school of economics.

Cost increase
Inflation is also caused by a rise in production costs that businesses have to bear. When this happens, firms have to raise prices to maintain their profit margins.

Monetary Policy
Inflation is also caused by an excess supply of money in the economy. Just like any other commodity, the prices of things are determined by supply and demand. If there is too much supply, the price of that product goes down. If the product is money, and too much money supply drives value down, the result is that the prices of all goods and services go up. This theory is often promoted by the "monetarist" school of economics.

The consequences of inflation

Inflation affects different people in different ways. It also depends on whether changes to the inflation rate are expected or unexpected. If the inflation rate matches what the majority of people are expecting then we can compensate and the impact is not necessarily that bad. For example, banks can adjust interest rates and workers can negotiate contracts that include automatic wage increases as prices rise.

Broadly speaking, we list the typical winners and losers of a rise in inflation.

The creditors lose out and the debtors gain through inflation. For example, suppose a bank grants us a 30-year mortgage to buy a house with a fixed rate of 5% a year, for a payment of €1,000 a month. As inflation rises, the "cost" of this $1,000 per month decreases, which works in the homeowner’s favor, especially if the inflation rate exceeds the interest rate on the loan.

Inflation disadvantages savers because every euro saved will be worth less in the future. Unless the money is kept in an account that pays an interest rate at or above the rate of inflation, but in general the purchasing power of savings goes down.

Workers with wages or contracts that do not follow inflation will be disadvantaged, the purchasing power of their incomes remains the same against a rise in prices.

Uncertainty about what will happen makes businesses and consumers less willing to spend, hurting economic output in the long run.
The whole economy has to absorb the costs of re-pricing: price lists, labels, menus and much more need to be updated.

If the domestic inflation rate is higher than that of other countries, domestic products become less competitive.

Inflation calculation: how is it measured?

Measuring inflation is tricky business for national statistical offices. It locates a set of goods that are representative of the economy within a "market basket." The cost of this basket is compared over time, which results in a price index, which is the cost of the market basket today as a percentage of the cost of the exact same basket in the previous year.

In the developed world, there are two main types of indices that measure inflation:

Consumer Price Index (CPI) - A measure of changes in the prices of consumer goods and services, such as gasoline, food, clothing, and automobiles. The CPI measures the price change from the perspective of the buyer.

Index of producer prices (PPI) - The index measures the average change over time in the selling prices of domestic producers of goods and services. The PPI measures the price change from the perspective of the seller.

We also have the GDP deflator as another useful tool for measuring inflation. As the name suggests, it is used to convert nominal GDP to real GDP. The GDP deflator is a broader measurement of the CPI and includes the goods and services purchased by businesses and governments.

We can think of price indices as big surveys. Each month, the National Statistical Office contacts thousands of stores, service providers, doctor’s offices and more to inquire about the prices of thousands of items used to track price changes that the CPI measures.

In the long run, the CPI and the PPI show a similar rate of inflation, but not in the short run as the PPI often rises before the consumer price index. In general, investors place more importance on the CPI than on producer prices.

The impact of inflation on investment

Inflation is a concern for investors, as changes in inflation and interest rates affect various types of investment assets in different ways.

The impact of inflation on your portfolio depends on the type of securities you hold. If you only invest in shares you can rest easy, as historically the stock market has a fairly good hedge against inflation. In the long run, a company’s revenues and earnings should rise at the same rate as inflation, so stock prices should rise along with the general prices of consumer and manufacturing goods.

The exception to this scenario is stagflation: the combination of a stagnant economy with rising costs is bad for stocks. Not all companies welcome a rise in inflation in the same way – for example, a company with a lot of cash will decline in value as inflation rises.

The more general problem on the stock market with inflation is that a company’s returns tend to be overvalued. In times of high inflation, a society may appear to be prosperous, when in fact, inflation is the reason behind the apparent growth.

Investors in fixed income (bonds) assets are the hardest hit by inflation. Suppose a year ago we invested $1,000 in government bonds with a yield of 10%. Now we are owed €1,100, but is this €100 (10%) return worth the same as €100 a year ago? Obviously not. Assuming that inflation has been positive for the year, our purchasing power has fallen and, consequently, our yield as well. We have to take into consideration the weight that inflation has on our return. If inflation was 4%, then our net return was 6%. Recall that inflation favors debtors at the expense of creditors: owning a bond is like being a lender.

Original article published on Money.it Italy 2022-10-20 10:11:06.
Original title: Cos’è l’inflazione? Significato e guida completa