What is Inflation?
Written by True Tamplin, BSc, CEPF®
Updated on July 27, 2021
While day-to-day the spending power of a dollar seems to remain the same, over long periods of time, the value of currency can increase or decrease.
As the price of goods in an economy increases, the buying power of an individual dollar (or euro, pound, yen, etc.) decreases proportionally in a process known as inflation.
In an inflating economy, the buying power of currency decreases as overall prices increase.
Defining Inflation in Simple Terms
Often expressed as a percentage, inflation is the rate at which the general price level of goods and services increases over a period of time.
Inflation makes everything you buy more expensive, so the value of your money decreases.
For example, many people are aware that generally speaking, commodities cost less a few decades ago than they do now; a cup of coffee, for instance, cost only $1.00 in 2000, but $1.25 in 2010.
This is due to sustained inflation that has been occurring over time.
In this case, the price change reflects a 25% inflation over 10 years.
Three Types of Inflation
Inflation is classified into three types; Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
1. Demand-Pull inflation
Demand-pull inflation is a situation where consumer demand for goods and services in an economy persistently exceeds the available supply when the economy is near or at full employment.
This results in a demand-supply gap with higher demand and a shortage in supply, causing prices to go up.
Demand-pull inflation is caused by excess demand, which can originate from high exports, strong investment, a rise in money supply, or government financing its spending by borrowing.
2. Cost-Pull inflation
Cost-push inflation is a result of the increase in the overall prices of production process inputs.
For example, an increase in the cost of labor and/or raw material will lead to higher overall production costs.
If the cost of making a product increases, then to stay profitable, businesses need to increase their prices accordingly.
Sometimes, companies may even seize the opportunity to grow their profit margins.
The more price inelastic the demand for their goods, the less likely such behavior will lead to a fall in demand for their products.
3. Built-in inflation
Built-in inflation occurs as the price of goods and services increases along with the demand for higher wages in order to maintain the cost of living.
Any upsurge in the labor wages would then result in the basket of goods and services getting more expensive, triggering a cost-pull inflation.
This wage-price spiral goes on as increases in one lead to increases in the other, and so on.
Pros and Cons of Inflation
The benefits and drawbacks of inflation are highly debated.
Many economists maintain that a slow rate of inflation is essential for keeping businesses profitable.
The key concept being “slow”inflation; the Federal Reserve aims for a rate of about 2% to 3% per year, in order to prevent consumers from simply avoiding making purchases until prices go down.
Other economists, however, argue that inflation is universally a drag on the economy because it makes saving harder.
They also argue that inflation only benefits a small number of business owners at the expense of consumers.
On the other side of the coin, uncontrolled inflation, also called hyperinflation, is a situation in which a country’s money supply increases at a rate that reduces the value of currency to near zero.
This has occurred a few times in history, such as in post WW1 Germany, where mass printing of German marks to pay for war reparations caused prices to increase to unpayable amounts; bread, for example, soared in price from a few cents to several billions of marks in the span of only a few years.
This makes buying impossible, and the economy stagnates.