What is Inflation
The term inflation characterizes a fundamental indicator for the economy not only of America but of the whole world. We hear about inflation daily as it allows us to understand the country's economic situation, and consequently, what is the purchasing power of the current currency. Let us, therefore, understand through this simple guide what inflation means and what dynamics this indicator is able to determine from an economic point of view.
Inflation: definition of inflation?
The meaning of this term indicates a significant increase in the level of prices of goods and services in a country. This indicator is conventionally measured on a monthly or annual basis as a percentage change. Under inflation conditions, when it increases, there is also a significant increase in prices automatically. So the purchasing power of money inevitably decreases with the possibility of buying a much lower percentage of goods and services. Trivially, when prices rise and fall the value of money, this is called inflation. The value of a currency is always expressed in terms of purchasing power; that is, the number of tangible goods or services that can be purchased through the currency. When inflation rises, there is, therefore, a drop in the purchasing power of the currency.
For example, if we consider an inflation rate of 4% per year, an asset that initially costs $1, with inflation; it will now cost $1.04.
Inflation is a general increase in the prices of goods and services, which decreases the purchasing power of money. The year that is taken as a reference is called the base year and is fundamental in the calculations. To obtain the price index, divide the amount of the different baskets after the basic one by the value of the basic basket, and multiply the result by 100. The inflation rate is obtained by subtracting the price index from the value just calculated and dividing everything by the price index of the previous year and then by 100.
Causes of inflation: what are they?
There is no theory that can determine deterministically what the causes that can trigger inflation are. In other words, it is not possible to predict its performance exactly. However, there are a number of variables that can influence their dynamics in a definitely significant way.
- Increased demand for goods and services.
A rather relevant factor which tends to inevitably increase prices. It goes without saying that at the same time that demand grows faster than supply, prices also rise proportionately. This situation tends to occur when the economy is growing rapidly.
- Increase in production costs.
A frequent situation that forces companies to inevitably increase the price of goods and services in order to maintain their profit margins.
- Monetary policy.
Inflation is often determined by an excess of the money supply in the economy because, as for material goods, prices are determined by supply and demand. When the product, in this case, is represented by money, an excessive supply of money leads to a loss of value with the result that the prices of all goods and services go up.
Types of inflation
Even if the result of inflation is always the same, the reasons behind it allow identifying two distinct types of inflation:
Demand inflation:
In this case, prices rise because demand from consumers and businesses grow. Supply is not adapting quickly enough to demand, and prices are rising.
Cost inflation:
In this case, the increase in prices is not caused by the growth in demand but by the increase in production costs (for example, raw materials, energy, labor costs).
Effects of inflation
The word "inflation" has a negative meaning and is often linked to negative consequences.
In reality, if the market and economic subjects manage to foresee this change, they can make adjustments to protect themselves from this phenomenon.
Unexpected and, therefore, unanticipated inflation is the one that hurts the most because it affects ongoing relationships by changing conditions.
It is, for example:
- Credit/debit relationships in which creditors following inflation receive a lower amount than expected (as the value of the currency decreases).
- The increase in prices also has a negative influence on all those whose income is fixed and cannot be adapted to market fluctuations.
- In macroeconomic terms, if the value of the inflation rate is far greater than in other countries, this can reduce the competitiveness of the inflated country.
- Uncertainty about the future pushes companies and consumers to spend less and save more to deal with any reversals of the system.
How to calculate inflation
As a rule, to calculate inflation, goods, and services that are relevant to the economy are gathered within a “market basket.” The cost of this basket is then compared with time, thus determining a price index. This index characterizes the cost of the above basket at present, compared with the cost of the same during the previous year. Specifically, two main indices are used that can measure inflation in a rather detailed way:
- Consumer price index or CPI
It is the measure of the prices of the main consumer goods and services, such as gasoline, cars, gastronomic products, and clothing, according to the point of view of consumers.
- Producer price index or IPP
It is the measure of the average variation of sales prices by national producers of goods and services, taken into consideration over time. This price change, in this case, is considered from the point of view of the seller or producer.
Then there is the GDP deflator, another useful tool when it comes to measuring inflation. As the name suggests, it is a price measurement tool used to convert GDP or nominal gross domestic product to Real GDP.
Finally, inflation always has a significant impact, even when it comes to investment. The trader should always keep in mind that they are just as actions to ensure a fairly safe hedge against inflation. For all the other assets, it is always advisable to analyze the country's market and economic situation in depth. Before deciding to invest your assets without being sure of a satisfactory future income due to the effects of inflation
, it is good to do some research.
Author: Vicki Lezama