One day, you go to the supermarket and buy products that you always need at home. Then, two weeks later, you do the same thing, only to find that what you buy costs slightly more. Why does this happen? The following is an explanation of how inflation is the cause of this situation. 

The economy has been constantly changing ever since bartering began in civilisation. From that time until now, there has been a constant flow of new products and services, with prices that change from one period to another. Goods can be bought using one of the official currencies of the various nations or supranational organisations, for example, the euro in the European Union. 

Each country uses its own parameters to analyse the performance of its particular economy and the events that occur in it. One of the most common factors is inflation, i.e. a general increase in prices that reduces people’s buying power and erodes their ability to purchase or save. 

To measure this effect, each country uses its own metrics. For example, inflation in Spain is calculated using the consumer price index (CPI), which reflects the trend in the prices of the most representative products and services consumed by households in the country. These include goods bought daily such as food; other products consumed over a longer time, such as household appliances and clothing; and services we buy in particular situations, e.g. home insurance. Then there is the harmonised index of consumer prices (HICP), for comparing prices with other countries in the European Union using a standard method based on European Central Bank criteria.

If this index rises persistently, people will save less and will be able to buy fewer goods and services for the same money. The currency we use loses value and uncertainty appears: what we are witnessing is a rise in inflation. 

What exactly causes inflation?

Among the reasons behind price fluctuations, we can find some of the more frequent causes of inflation. The main one is the imbalance between supply and demand, when a large number of consumers try to buy scarce goods. Just as important, however, is the opposite situation – excess supply is equally negative for a country. When there is insufficient demand to meet supply, the opposite to inflation occurs, i.e. negative inflation or deflation.

Inflation may also occur as a result of rising costs for companies, e.g. the price of electricity or of logistics services. This has a knock-on effect on the price at which they will offer their services. Another cause is an increase in the amount of money in circulation in a particular country. This must be controlled since an imbalance could arise in the system if demand fails to increase despite sufficient money supply. 

Now that we have seen the causes behind inflation, we should understand the various levels: 

  • Moderate inflation: a slight annual increase in prices (under 10%). 
  • Rampant inflation: two or three digit annual inflation with a very negative impact on the economy of a country. As the value of money drops, people focus their spending on essential goods. 
  • Hyperinflation: if a nation is affected by this type of inflation, it means it is suffering a severe economic crisis. According to Steve Hanke, a professor at the Johns Hopkins University, in an interview with the BBC: “The generally accepted definition of hyperinflation among economists is monthly inflation in excess of 50%.” The value of money plummets as a result.

Significant inflation accompanied by a stagnant economy is called “stagflation”. This term was coined during the 1970s oil crisis, when inflation had a devastating impact on the several countries’ economies, which grew slowly as a result. 

Why does inflation affect a country’s economy?

Although inflation is a term commonly associated with negative effects, some countries use it to balance their economies, by stimulating activity and consumption. However, inflation should be managed moderately and occasionally. Otherwise, the consequences could be serious for the financial health of both consumers and the state.

The most important effects, as mentioned above, are the devaluation of the currency, a reduction in households’ purchasing power and saving capacity, and economic uncertainty. 

Would you like to know how monetary policy is used for controlling inflation and deflation? Find out here: Finance for Mortals

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