Inflation Definition

What Is Inflation?

Inflation is the rate of increase in the prices of goods and services within an economy over a given period. It indicates the change of prices over time.

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Inflation is the rate at which prices of goods and services increase over time[1].

Generally, inflation is expressed as a percentage amount[2], which compares how costly commodities are to a previous index. Economists calculate inflation in reference to this index (e.g., Consumer Price Index), which uses a predetermined combination of goods and services and how their prices change over time.

inflation

Determining inflation is useful for economists and policymakers. For example, the higher price of a commodity means much more currency units are required to buy it than before. Therefore, the value of money in an inflationary period decreases—in other words, the purchasing power of that currency is reduced.

The impact of inflation is universal. It affects the prices of essential goods and services, such as housing, food, utilities, and medical care. Inflation also impacts non-essentials like luxury apparel, cosmetics, and jewelry.

Runaway inflation in an economy is a cause of concern for businesses and consumers alike. Since inflation erodes the ability of consumers to spend[3], it can eventually lead to slower business growth. In addition, it could have adverse effects on banking and investments.

What Causes Inflation?

Many factors bring about inflation, but these causes mainly revolve around a pair of causes, namely[4]:

  1. Supply and demand imbalance. Rising demand for goods and services amid declining supply prompts manufacturers and service providers to increase their prices to maximize profits.
  2. Rising production cost. Manufacturers saddled with the increasing cost of production raise prices to preserve their profit margins.

The fiscal and monetary policies of the government can also bring a major influence on inflation[5]. The Federal Reserve, for instance, can adopt an expansionary monetary policy by enhancing credit availability at lower rates to stimulate economic growth.

This policy encourages business expansion and job generation. The rising employment, in turn, opens the possibility of an increase in demand for goods and services, which may lead to inflation. Higher wages and their boost on consumers’ purchasing power can also significantly increase the money supply, which devalues the existing cash in circulation.

federal reserve

Exchange rate fluctuations constitute another factor that can influence inflation[6]. For example, a decline in the dollar’s forex rate can lead to more expensive importation fees, both for finished products and raw materials. The resulting higher production costs raise prices, thus contributing to inflationary pressure.

BY THE NUMBERS: Over 65 countries have their currencies pegged to the U.S. dollar. The dollar is also legal tender in five U.S. territories and seven sovereign countries.

Source: Investopedia

Effects of Inflation on the Real Estate Market

Inflation directly affects the housing market, primarily on mortgages.

When inflation rises, the Federal Reserve increases interest rates to act as a “brake”[7] on the overheating economy. People are more inclined to save their money in a high-interest rate environment due to a higher return on savings. As a result, the demand for goods and services declines, dampening inflation.

However, higher interest rates due to inflation will also raise the interest rates on mortgages. Interestingly enough, higher mortgage rates can create a buyer’s market because fewer people are willing to shoulder debt. As a result, home values fall and house prices decline.

Is Real Estate a Hedge Against Inflation?

inflation hedge

A Stanford University study[8] has concluded that real estate, particularly residential, can be considered safe havens in inflationary periods. There are three main reasons for this:

  • Rent prices often rise with inflation, which creates bigger cash flows for landlords.
  • Properties appreciate faster.
  • Inflation devalues fixed-rate loans because borrowers tend to pay lenders money worth less when they originally took out the loan[9].

However, real estate investors should keep in mind that they increase rent commensurate with inflation. Therefore, landlords often increase rent at least by the rate of inflation to keep up with the increase in prices of other goods.

Types of Inflation

This category aims to classify inflation based on its specific causes and characteristics.

inflation demand-pull

  • Demand-pull inflation. This happens when prices rise because of low market supply but high consumer demand.
  • Cost-push inflation. This type of inflation occurs when production cost rises because of costlier raw materials. It can also happen due to increased taxes that can prompt price hikes.
  • Wage inflation. This combines the characteristics of demand-pull and cost-push inflation. Increasing wages raises production costs, eventually leading to higher consumer prices. Rising wages also boost consumers’ disposable incomes, further spurring higher demand.
  • Imported inflation. Depreciation of local currency results in more expensive imports. Imported finished products and raw materials are priced higher, triggering a chain reaction down the supply line. Foreign exchange depreciation can also lead to more competitive exports, thus stimulating higher wages, and finally driving domestic demand and price increase.

Rates of Inflation

The rate of inflation aims to measure the pace of inflation over time.

  • Creeping inflation (1–4%). Low-velocity inflation may not be noticeable right away. However, if it persists progressively, this can be a concern.
  • Walking inflation (2–10%). Also called moderate inflation, walking inflation is concerning, but manageable.
  • Running inflation (10–20%). Inflation of this type accelerates at a significant pace. It imposes substantial economic costs and could easily shift to even higher levels.
  • Galloping inflation (20–1000%). At this rapid velocity, inflation is already serious and challenging to control.
  • Hyperinflation (>1000%). This extreme form of inflation typically manifests in the daily escalation of prices and the rapid decline in a country’s currency value.
Zimbabwe dollar hyperinflation

The meme-famous Zimbabwean dollar, an example of extreme hyperinflation. In 2008, it took 2 billion Zimbabwean dollars for one U.S. dollar. However, less than a month later, this exchange rate accelerated to 1 trillion Zimbabwean dollars for 1 U.S. dollar.

Concepts Related to Inflation

The dynamics of market prices within an economy also gave rise to several terminologies related to inflation. These include the following:

  • Disinflation. This means a decline in the inflation rate where price increases are slower.
  • Deflation. It refers to a negative inflation rate resulting from a decline in prices.
  • Shrinkflation. It describes prices at steady levels, but manufacturers reduce their products’ size—a price increase in effect.
  • Stagflation[11]. A wordplay on stagnation and inflation, stagflation describes slow economic growth, high unemployment, and rising inflation.

How Inflation Is Measured: CPI and PCE

There are two most frequently used indexes[12] calculating U.S. inflation. One is the Consumer Price Index (CPI) of the Bureau of Labor Statistics (BLS) and the other is the Personal Consumption Expenditures (PCE) Price Index of the Bureau of Economic Analysis (BEA). Both indexes use a predetermined basket of goods to measure inflation.

Calculating the CPI is based on the data from its survey on consumers’ spending for a basket of goods and services. The BLS takes the average weighted cost of this basket. Then, it divides this cost by the weighted average of the previous month to calculate CPI inflation.

CPI market basket

The PCE is also a widely used inflation gauge. BEA’s PCE calculation is similar to the BLS’s. However, unlike the CPI that bases its report on consumer surveys, the PCE tracks the prices that businesses report on the goods and services they sell. This way, the PCE can better track expenses that consumers indirectly pay, like employer-paid medical care.

Compared with CPI’s, PCE’s consumer basket is also more flexible in its components. It can account for consumer substitution when certain goods or services become more expensive.

BY THE NUMBERS: The BLS records the prices of about 80,000 items in its basket of goods and services monthly to calculate CPI inflation.

Source: BLS

Takeaways

  • Inflation indicates the pace of increases in the prices of goods and services within a certain period. It can be triggered by higher demand and low supply, rising production costs, or both.
  • Inflation impacts essential and non-essential goods and services, thus creating a far-reaching effect on an economy. Higher inflation also means a lower purchasing power of each unit of currency.
  • There are two main ways to measure inflation: the CPI and the PCE. These two indexes give economists and policymakers an idea of how much prices are changing, the direction of the market, and some fiscal policies they can use to control inflation.

Reviewed by Jay Wu, the founder of Money Knock, an online hub for remote workers and finance nerds.

Sources

  1. Oner, C. (n.d.) Inflation: Prices on the Rise. International Monetary Fund. Retrieved from https://www.imf.org/external/pubs/ft/fandd/basics/30-inflation.htm
  2. Flynn, J. (2021.) How to Calculate the Inflation Rate (with Examples). Zippia. Retrieved from https://www.zippia.com/advice/how-to-calculate-inflation-rate/
  3. Investopedia. (2021.) What Causes Inflation and Who Profits from It? Retrieved from https://www.investopedia.com/ask/answers/111314/what-causes-inflation-and-does-anyone-gain-it.asp
  4. Simon, J. (2021.) What Are the Causes of Inflation? Smart Asset. Retrieved from https://smartasset.com/investing/what-causes-inflation
  5. The Federal Reserve. (n.d.) How does the Federal Reserve affect inflation and employment? Retrieved from https://www.federalreserve.gov/faqs/money_12856.htm
  6. Chaluvadi, S. (2021.) Inflation Meaning. Scripbox. Retrieved from https://scripbox.com/pf/inflation/
  7. Reinicke, C. (2022.) Inflation is at its highest in 40 years. Here’s how raising interest rates could help. CNBC. Retrieved from https://www.cnbc.com/2022/02/15/why-the-fed-raises-interest-rates-to-combat-inflation.html
  8. Leombroni, M., Piazzesi, M., et al. (2020.) Inflation and the Price of Real Assets. Department of Economics, Stanford University. Retrieved from https://web.stanford.edu/~piazzesi/inflationAP.pdf
  9. Wolfe, M. (n.d.) How Is Debt Handled With Currency Devaluation? Sapling. Retrieved from https://www.sapling.com/8117368/debt-handled-currency-devaluation
  10. Pettinger, T. (2021) Different Types of Inflation. Economics Help. Retrieved from https://www.economicshelp.org/blog/2656/inflation/different-types-of-inflation/
  11. Folger J. (2021.) What Is Stagflation? The Economic Phenomenon That Stifled Growth through the 1970s. Business Insider. Retrieved from https://www.businessinsider.com/stagflation
  12.  Lavie, D., Curry, B. (2021). How to Measure Inflation: PCE & CPI. Forbes Advisor. Retrieved from https://www.forbes.com/advisor/investing/how-to-calculate-inflation/

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