Inflation Explored: All You Need to Know

Inflation: The Basics

Inflation is an economic term that describes the rise in the prices of goods and services within the economy over time.

This term also describes the diminishing purchasing power for consumers and businesses in a country or economy. In other words, your currency reduces in value than it was a day before.

For instance, if a chocolate bar’s price was $2 last year and has now become $3.5 - this indicates that inflation has indeed taken place.

Simply explained, your money's purchasing power diminishes during times of inflation. If you had $100 last year and could buy ten chocolate bars, if your $100 could only get you 9 bars now, this means that the economy of your country is experiencing inflation.

Here is a good example of inflation in action: In Nigeria, the price of petrol was estimated at ₦200 per litre, and you needed ₦2,000 to fill your 10-litre tank. Today, this has gone up to ₦300 per litre, so the citizens who use petrol in their cars need more money to fill up a 10-litre tank. That is an extra ₦1000 as a result of inflation.

You should know that inflation is unavoidable in every economy as the price of goods and services in every country increases over time.

However, it depends on each and every country, some have it easier than others.  Moreover, a moderate percentage of a 2% increase in inflation yearly is considered normal and beneficial for the economy.

On the contrary, an inflation rate of 10% or more is deemed as problematic and harmful for any economy.

How does it work?

Inflation affects various aspects of consumer living by diminishing household purchasing power, meaning more money will be spent to purchase the same amount of goods and services.

In most cases, households are not able to increase their budget, leading them to reduce the amount of goods or services purchased monthly or yearly.  

Inflation Indicators 

Rising Prices: When everyday goods and services become more expensive and experience quick changes in prices, this indicates that inflation is taking place.

Increasing Interest Rates: A rise in interest rates is often experienced as a measure to control inflation within an economy. The government deliberately increases interest rates on loans to make borrowing more expensive. When this happens, people normally  spend less, slowing the economy, but this is mostly not the case as inflation makes people pay more for the same amount of goods and services that they could easily afford before.

Decreasing Value of Money: If the same amount can't buy what it used to, it hints that money's value has decreased due to inflation.

Demand Outpacing Supply: If everyone wants the latest gadgets, but there aren't enough, prices tend to rise, thus dissuading people to cut down on their demand.

Causes of Inflation

Here's what can cause inflation:

1. Government Spending
When the government spends more than it collects in taxes, it may borrow or print money to cover the deficit.

This increases money supply and demand for goods and services, thereby leading to inflation. This can also result from a government’s plans to boost the economy or handle emergencies like wars.

2. Speculation
When people expect price rises, they buy more goods and services to avoid higher future prices. 
This boosts demand for goods and services, which in turn causes inflation. This can also happen during market bubbles, like in the stock, housing, or commodity markets.

3. Market Power
When firms or industries have significant market power, they can charge higher without losing customers. 
This raises production or sales costs and prices, which indirectly contributes to inflation. This occurs in monopolies, oligopolies, or cartels in the market.

Types of Inflation 

Inflation falls under several brackets.

Cost-Push Inflation
Cost-push inflation happens when the cost of production rises high, thereby pushing companies to charge more for their products or services.

When factors like increased wages, rising prices of raw materials, higher production costs, scarcity, economic policies, increased energy usage, etc, affect businesses, they often respond by bumping up the prices of goods and services to stay profitable.

Natural disasters or geopolitical events can also disrupt the production process, contributing to cost-push inflation.

To tackle cost-push inflation, measures like controlling wage increases, managing production costs, and promoting economic stability are vital measures to take. Government policies that address these factors can help keep inflation in check.

Demand-Pull Inflation
Demand-pull inflation occurs when prices of goods and services go up because consumer demand for these things exceeds supply.

High demand for goods/services by consumers leads to shortages, and sellers, in turn, increase prices to balance supply and demand.

It can be caused by economic growth, increases in salaries, increased consumer spending, or excessive government spending, which can fuel this type of inflation.

Measures like reducing spending (government or consumer), increasing interest rates, or implementing policies can be used to balance supply and demand.

Built-in Inflation
Built-in inflation occurs due to expectations that inflation will continue, so wages must rise in order to maintain the status quo.

As the prices of goods and services increase, labour expects to be paid more to maintain their standard of living.

Accordingly, the consumer prices for good or services that labour produces or provides also increase.

How Does Inflation Affect the Economy? 

Although inflation seems harmful to an economy, there is still a positive side to it.

1. Prevents Deflation 
Inflation prevents harmful deflation, encouraging consumer spending and economic growth. You should know that deflation can lead to delayed purchases and reduced business activity, affecting overall economic health.

2. Facilitates Wage and Price Adjustments
Inflation allows for more effortless adjustment of nominal wages and prices, reducing unemployment and improving efficiency. This flexibility helps adapt to changing economic conditions, ensuring smoother labour and market dynamics.

3. Boosts Economic Growth 
A moderate rate signals a healthy economy, promoting spending, investment, and innovation. It can enhance export competitiveness and stimulate borrowing and spending. This economic stimulation fosters job creation and technological advancements.

4. Impacts the Value of Money
It is advantageous for debtors and the government, reducing the real value of debt and interest payments. Inflation encourages investment and spending. This impact on a currency’s value incentivises economic activity over hoarding, contributing to a more dynamic economy.

The Downside of Inflation 

1. Reduces Purchasing Power
Inflation lowers the standard of living of the citizens within a country experiencing a harsh inflation climate by diminishing the purchasing power of their money and in turn, negatively impacting savings, investments, and retirement plans.

As people buy less with the same amount of money, it creates challenges for maintaining a comfortable lifestyle and financial security.

2. Causes Uncertainty 
Rapid and unpredictable price changes create economic planning difficulties, reducing confidence and trust in the economy. Uncertainty can lead to hesitations in investment and consumption, hindering overall economic stability.

3. Diminishes International Competitiveness
Rising domestic prices can harm exports and worsen trade balances, which leads to currency depreciation. This reduction in competitiveness can result in economic imbalances and trade deficits, which affects the country's global financial standing.

4. Creates a Vicious Cycle 
High and uncontrollable inflation can trigger a self-reinforcing spiral, causing hyperinflation and economic collapse. The cycle of rising prices and expectations can undermine the stability of financial systems and disrupt societal order, posing severe challenges to sustained economic well-being.

How Is Inflation Calculated?

A good number of inflation calculators are already available on different financial websites.

However, the old-fashioned way of calculating inflation goes like this:

Percent Inflation Rate = (Final CPI Index Value ÷ Initial CPI Value) x 100

Closing Notes

Despite its negative effects on the overall economy, inflation is present in a good chunk of countries. 

Venezuela ranks as the number one country with the highest inflation rate in the world. As of November 2023, the country had an inflation rate of 283%. 

Countries suffering from very high inflation include Lebanon, Sudan, Argentina, and Turkey. 

Inflation is also expected to carry on throughout 2024, with many central banks adjusting interest rates to battle this economic phenomenon.