Inflation

Inflation is taxation without legislation

Milton Friedman

What is Inflation?

Inflation refers to the sustained increase in the general level of prices for goods and services in an economy over a period of time. When inflation occurs, each unit of currency buys fewer goods or services than it could previously. 

Inflation is usually measured as an annual percentage increase in the price of a basket of goods and services. Inflation can be caused by a variety of factors, such as an increase in the money supply, an increase in demand for goods and services that outstrips supply, or a decrease in the supply of goods and services.

What causes Inflation?

Inflation is caused by a disequilibrium in the supply and demand of the monetary base (see out Money Supply article here for more details).

If the demand for goods or services increases but the supply remains the same or goes down this will most likely pull the price up. For example, the price of wheat can go up for many reasons such as bad weather, distribution issues, war, and more. This will make the price of the bread more expensive. Every single element of the basket is affected by supply and demand.

The reverse is also true. If demand for goods and services decreases relative to the money supply, there is too much money chasing the same number of goods which in turn deflation. This typically happens in periods of stagnation in production and sustained recessions.

Central banks monetary policies also affect inflation, either directly or indirectly. A common example is the use of interest rates, which are lowered to encourage investments and consumer spending and borrowing, or increased to discourage those activities.

Is Inflation a problem?

While some level of inflation is generally considered healthy for an economy, high and persistent inflation can be detrimental to economic growth, stability, and prosperity. 

The perfect scenario would be to have a bit of everything but not too much of a single thing: a good employment rate is nice, but full employment is bad because it can generate inflation (the same goes for wages).

At the same time, high inflation is very bad, but some inflation (the FED’s current mandate is 2%) is good because it makes the economy healthy. Simply, too much inflation is no longer healthy for an economy to grow sustainably.

What are the effects of Inflation?

Inflation can have a range of effects on an economy, some of which are positive, but high and persistent inflation can be dangerous for several reasons. We break down the main ones to keep in mind as follows: 

• Reduced Purchasing Power: Inflation reduces the purchasing power of money. As the price of goods and services rises, people can afford to buy less, which can lead to reduced economic activity and lower standards of living.
• Reduced Savings: Inflation can also reduce the value of savings, which can discourage people from saving and investing, leading to a slower rate of economic growth in the long run.
• Uncertainty: high and volatile inflation can make it difficult for businesses to plan and invest, leading to a reduction in economic growth and job creation.
• Redistribution of Wealth: Inflation can also result in the redistribution of wealth from savers to borrowers, as the value of debts decreases in real terms, while the value of savings and fixed-income assets declines.
• International Competitiveness: high inflation can make a country’s exports more expensive and less competitive in the global market, leading to a negative impact on trade and economic growth.

How can Central Banks tackle Inflation?

While raising interest rates is a tool that central banks can use to combat inflation, it is not always the best approach. The potential economic damage caused by raising interest rates too quickly or too aggressively may outweigh the benefits of slowing inflation.

If the central bank is facing an inflation problem that requires action, there may be other policy tools available that can achieve the desired outcome with less risk of damaging the economy. For example, the central bank could use open market operations to adjust the money supply or implement targeted regulations to address specific areas of the economy where inflation is a problem.

Conclusion

Eventually, raising interest rates to combat inflation can pose risks to economic growth, employment, asset prices, exchange rates, and government budgets. As such, central banks must carefully consider the potential costs and benefits of any policy action to combat inflation, including the risks of raising interest rates.

Ultimately, the decision to raise interest rates to fight inflation must be made based on a careful analysis of the situation and the potential outcomes. It is a complex issue that requires a nuanced and informed approach.