What is inflation and how is it calculated?
What are the causes of inflation?
Inflation and the role of central banks
Economic stagnation + inflation = stagflation
Inflation, stagflation and deflation are all three economic phenomena that have in common that they describe how the purchasing value of a currency changes over time.
Inflation is the loss of purchasing power of a currency. Concretely, it manifests itself in the rising prices of goods and services. Now, it is clear that the value of individual goods or services can fall or rise very differently over time. For this reason, inflation is calculated on the basis of a basket of the goods most representative of household consumption: basic consumer goods, energy costs, but also rents and many types of everyday services, such as transport or hairdressing. Of course, each product affects as a percentage in the basket proportionally to how it affects on average the household budget. In the UK, inflation figures are published by the Office for National Statistics, which releases monthly Consumer Price Index (CPI) figures. It is usually specified if the cost of housing is also included in the index. In this case it is called the Consumer Price Index with Housing (CPIH).
Economic theory does not identify a single root cause of inflation, but at least three:
Central banks around the world are certainly the most responsible institutions for managing inflation. The declared goal of many of them (Federal Reserve, European Central Bank, Bank of England, Swiss National Bank, People's Bank of China, and so on) is to keep inflation within certain limits - usually a range of between 2-3% per year. In this case, inflation is physiological, as it is a sign of a growing economy, in which demand increases and production strives to meet it through supply. In the event that inflation should fall out of that range, central banks have two paths: a) in the case of rising inflation, they can raise interest rates, i.e. increase the cost of borrowing money so as to act on demand, thereby curbing it; b) in the case of deflation (see below), central banks can lower interest rates on credit and/or inject liquidity into the markets (e.g. by buying bonds), so as to stimulate aggregate demand.
Above a certain level, however, inflation can be a serious problem for households and businesses. It actually erodes wealth and hinders its growth. On the one hand, households find themselves having to spend more and more to buy the same goods and are in some cases even forced to limit their spending. On the other hand, companies that raise the prices of their goods and services risk losing buyers in the domestic market and competitiveness in the foreign market. There are three ways of defining inflation: i) creeping, if it does not exceed 10% each month but remains constant over time; ii) galloping, if it starts to get out of control, exceeding a rate of 10% each month; iii) hyper-inflation, if it exceeds levels that are now difficult to control, i.e. over 50% per month .
Inflation, however, can occur in some cases not necessarily in the presence of economic growth. A situation can arise in which a recession is compounded by a sudden increase in certain types of prices. For example, this is what happened in the 1970s in Western countries. The economic cycle following the great economic boom of the 1950s-1960s was characterized by a situation of stagnation, caused by the slowdown in production growth; added to this, however, was the sudden rise in oil prices, the famous energy crises of 1973 and 1979, also known as “oil shocks”. The phenomenon of stagflation is also called “recessionary inflation”.
In economics, there is also a phenomenon in which there is an increase in the value of circulating money. This is called deflation. It usually occurs in an environment where aggregate demand contracts, forcing producers of goods and services to lower prices in an attempt to dispose of as much excess supply as possible. The scenarios in which deflation typically occurs are twofold: a) if wages fall, consumers literally do not have the money to continue supporting aggregate demand; b) if consumers decide to postpone their purchases, hoping that prices will fall further, they generate a deflationary spiral.
This picture can be completed by mentioning two other factors that, especially in recent decades, have acted as a deflationary force: c) globalisation, which has relocated production areas, reduced production costs and lowered prices, forcing many other producers to do so as well, so as not to find themselves out of the market; d) automation, which has always acted in the direction of lowering prices, in many cases making labour unnecessary.
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