Module 4
Inflation
What is inflation?
Inflation is the gradual loss of purchasing power, reflected in a broad rise in prices
for goods and services. Inflation refers to a broad rise in the prices of goods and
services across the economy over time, eroding purchasing power for both
consumers and businesses. In other words, your dollar (or whatever currency you
use for purchases) will not go as far today as it did yesterday. To understand the
effects of inflation, take a commonly consumed item and compare its price from one
period with another.
For example, in 1970, the average cup of coffee cost 25 cents; by 2019, it had
climbed to $1.59. So for $5, you would have been able to buy about three cups of
coffee in 2019, versus 20 cups in 1970. That is inflation, and it isn’t limited to price
spikes for any single item or service; it refers to increases in prices across a sector,
such as retail or automotive—and, ultimately, a country’s economy.
In a healthy economy, annual inflation is typically in the range of two percentage
points, which is what economists consider a signal of pricing stability. And there can
be positive effects of inflation when it’s within range: for instance, it can stimulate
spending, and thus spur demand and productivity, when the economy is slowing
down and needs a boost. Conversely, when inflation begins to surpass wage growth,
it can be a warning sign of a struggling economy.
Inflation affects consumers most directly, but businesses can also feel the impact.
Here’s a quick explanation of the differences in how inflation affects consumers and
companies: Households, or consumers, lose purchasing power when the prices of
items they buy, such as food, utilities, and gasoline, increase.
Companies lose purchasing power, and risk seeing their margins decline, when
prices increase for inputs used in production, such as raw materials like coal and
crude oil, intermediate products such as flour and steel, and finished machinery. In
response, companies typically raise the prices of their products or services to offset
inflation, meaning consumers absorb these price increases. For many companies, the
trick is to strike a balance between raising prices to make up for input cost increases
while simultaneously ensuring that they don’t rise so much that it suppresses
demand, which is touched on later in this article.
What are the types of inflation?
There are two primary types, or causes, of inflation:
Demand-pull inflation occurs when an increase in the supply of money and credit
stimulates the overall demand for goods and services to increase more rapidly than
the economy's production capacity. This increases demand and leads to price rises.
When people have more money, it leads to positive consumer sentiment. This, in
turn, leads to higher spending, which pulls prices higher. It creates a demand-supply
gap with higher demand and less flexible supply, which results in higher prices.
For example, when demand for new cars recovered more quickly than anticipated
from its sharp dip at the beginning of the COVID-19 pandemic, an intervening
shortage in the supply of semiconductors made it hard for the automotive industry
to keep up with this renewed demand. The subsequent shortage of new vehicles
resulted in a spike in prices for new and used cars.
Photo by Investopedia
Cost-push inflation is a result of the increase in prices working through the
production process inputs. When additions to the supply of money and credit are
channeled into a commodity or other asset markets, costs for all kinds of
intermediate goods rise. This is especially evident when there is a negative economic
shock to the supply of key commodities.
These developments lead to higher costs for the finished product or service and work
their way into rising consumer prices. For instance, when the money supply is
expanded, it creates a speculative boom in oil prices. This means that the cost of
energy can rise and contribute to rising consumer prices, which is reflected in various
measures of inflation.
For example, commodity prices spiked sharply during the pandemic as a result of
radical shifts in demand, buying patterns, cost to serve, and perceived value across
sectors and value chains. To offset inflation and minimize impact on financial
performance, industrial companies were forced to consider price increases that
would be passed on to their end consumers.
Built-in Inflation
Built-in inflation is related to adaptive expectations or the idea that people expect
current inflation rates to continue in the future. As the price of goods and services
rises, people may expect a continuous rise in the future at a similar rate. As such,
workers may demand more costs or wages to maintain their standard of living. Their
increased wages result in a higher cost of goods and services, and this wage-price
spiral continues as one factor induces the other and vice-versa.
How does inflation today differ from historical inflation?
In January 2022, inflation in the United States accelerated to 7.5 percent, its highest
level since February 1982, as a result of soaring energy costs, labor mismatches, and
supply disruptions. But inflation is not a new phenomenon; countries have weathered
inflation throughout history.
A common comparison to the current inflationary period is with that of the post–
World War II era, when price controls, supply problems, and extraordinary demand
fueled double-digit inflation gains—peaking at 20 percent in 1947—before
subsiding at the end of the decade, according to the US Bureau of Labor Statistics.
Consumption patterns today have been similarly distorted, and supply chains have
been disrupted by the pandemic.
The period from the mid-1960s through the early 1980s, deemed as “The Great
Inflation,” saw some of the highest rates of inflation, with a peak of 14.8 percent in
1980. To combat this inflation, the Federal Reserve raised interest rates to nearly 20
percent. Some economists attribute this episode partially to monetary policy
mistakes rather than to other purported causes, such as high oil prices. The Great
Inflation signaled the need for public trust in the Federal Reserve’s ability to lessen
inflationary pressures.
How does inflation affect pricing?
When inflation occurs, companies typically pay more for input materials. One way
for companies to offset losses and maintain gross margins is by raising prices for
consumers, but if price increases are not executed thoughtfully, companies can
damage customer relationships, depress sales, and hurt margins. An exposure matrix
that assesses which categories are exposed to market forces, and whether the market
is inflating or deflating, can help companies make more informed decisions.
Causes of Inflation
An increase in the supply of money is the root of inflation, though this can play out
through different mechanisms in the economy. A country's money supply can be
increased by the monetary authorities by:
• Printing and giving away more money to citizens
• Legally devaluing (reducing the value of) the legal tender currency
• Loaning new money into existence as reserve account credits through the
banking system by purchasing government bonds from banks on the
secondary market (the most common method)
In all of these cases, the money ends up losing its purchasing power.
Indices of Inflation
Depending upon the selected set of goods and services used, multiple types of
baskets of goods are calculated and tracked as price indexes. The most commonly
used price indexes are the Consumer Price Index (CPI), Producer Price Index (PPI)
and the Wholesale Price Index (WPI).
The Consumer Price Index (CPI)
The CPI is a measure that examines the weighted average of prices of a basket of
goods and services which are of primary consumer needs. They include
transportation, food, and medical care.
CPI is calculated by taking price changes for each item in the predetermined basket
of goods and averaging them based on their relative weight in the whole basket. The
prices in consideration are the retail prices of each item, as available for purchase by
the individual citizens.
Changes in the CPI are used to assess price changes associated with the cost of
living, making it one of the most frequently used statistics for identifying periods of
inflation or deflation. In the U.S., the Bureau of Labor Statistics (BLS) reports the
CPI on a monthly basis and has calculated it as far back as 1913
The Consumer Price Index For All Urban Consumers (CPI-U) introduced in 1978,
represents the buying habits of approximately 88% of the non-institutional
population of the United States.
The Wholesale Price Index (WPI)
The WPI is another popular measure of inflation. It measures and tracks the changes
in the price of goods in the stages before the retail level.
While WPI items vary from one country to other, they mostly include items at the
producer or wholesale level. For example, it includes cotton prices for raw cotton,
cotton yarn, cotton gray goods, and cotton clothing.
Although many countries and organizations use WPI, many other countries,
including the U.S., use a similar variant called the producer price index (PPI).
The Producer Price Index (PPI)
The PPI is a family of indexes that measures the average change in selling prices
received by domestic producers of intermediate goods and services over time. The
PPI measures price changes from the perspective of the seller and differs from the
CPI which measures price changes from the perspective of the buyer.
In all variants, it is possible that the rise in the price of one component (say oil)
cancels out the price decline in another (say wheat) to a certain extent. Overall, each
index represents the average weighted price change for the given constituents which
may apply at the overall economy, sector, or commodity level.
For example, in the United States, that country’s Bureau of Labor Statistics publishes
its Consumer Price Index (CPI), which measures the cost of items that urban
consumers buy out of pocket. The CPI is broken down by regions and is reported for
the country as a whole.
The Personal Consumption Expenditures (PCE) price index—published by the US
government’s Bureau of Economic Analysis—takes into account a broader range of
consumers’ expenditures, including healthcare. It is also weighted by data acquired
through business surveys.
How is inflation measured?
Statistical agencies measure inflation by first determining the current value of a
“basket” of various goods and services consumed by households, referred to as a
price index. To calculate the rate of inflation, or percentage change, over time,
agencies compare the value of the index over one period to another, such as month
to month, which gives a monthly rate of inflation, or year to year, which gives an
annual rate of inflation.
The Formula for Measuring Inflation
The above-mentioned variants of price indexes can be used to calculate the value of
inflation between two particular months (or years). While a lot of ready-made
inflation calculators are already available on various financial portals and websites,
it is always better to be aware of the underlying methodology to ensure accuracy
with a clear understanding of the calculations. Mathematically,
Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100
Say you wish to know how the purchasing power of $10,000 changed between
September 1975 and September 2018. One can find price index data on various
portals in a tabular form. From that table, pick up the corresponding CPI figures for
the given two months. For September 1975, it was 54.6 (initial CPI value) and for
September 2018, it was 252.439 (final CPI value).89 Plugging in the formula yields:
Percent Inflation Rate = (252.439/54.6) x 100 = (4.6234) x 100 =
462.34%
Since you wish to know how much $10,000 from September 1975 would worth be
in September 2018, multiply the inflation rate by the amount to get the changed
dollar value:
Change in Dollar Value = 4.6234 x $10,000 = $46,234.25
This means that $10,000 in September 1975 will be worth $46,234.25. Essentially,
if you purchased a basket of goods and services (as included in the CPI definition)
worth $10,000 in 1975, the same basket would cost you $46,234.25 in September
2018.
Advantages and Disadvantages of Inflation
Inflation can be construed as either a good or a bad thing, depending upon which
side one takes, and how rapidly the change occurs.
Pros
Individuals with tangible assets (like property or stocked commodities) priced in
their home currency may like to see some inflation as that raises the price of their
assets, which they can sell at a higher rate.
Inflation often leads to speculation by businesses in risky projects and by individuals
who invest in company stocks because they expect better returns than inflation.
An optimum level of inflation is often promoted to encourage spending to a certain
extent instead of saving. If the purchasing power of money falls over time, then there
may be a greater incentive to spend now instead of saving and spending later. It may
increase spending, which may boost economic activities in a country. A balanced
approach is thought to keep the inflation value in an optimum and desirable range.
Cons
Buyers of such assets may not be happy with inflation, as they will be required to
shell out more money. People who hold assets valued in their home currency, such
as cash or bonds, may not like inflation, as it erodes the real value of their holdings.
As such, investors looking to protect their portfolios from inflation should consider
inflation-hedged asset classes, such as gold, commodities.
High and variable rates of inflation can impose major costs on an economy.
Businesses, workers, and consumers must all account for the effects of generally
rising prices in their buying, selling, and planning decisions. This introduces an
additional source of uncertainty into the economy, because they may guess wrong
about the rate of future inflation. Time and resources expended on researching,
estimating, and adjusting economic behavior are expected to rise to the general level
of prices. That's opposed to real economic fundamentals, which inevitably represent
a cost to the economy as a whole.
Even a low, stable, and easily predictable rate of inflation, which some consider
otherwise optimal, may lead to serious problems in the economy. That's because of
how, where, and when the new money enters the economy. Whenever new money
and credit enters the economy, it is always into the hands of specific individuals or
business firms. The process of price level adjustments to the new money supply
proceeds as they then spend the new money and it circulates from hand to hand and
account to account through the economy.
Inflation does drive up some prices first and drives up other prices later. This
sequential change in purchasing power and prices means that the process of inflation
not only increases the general price level over time. But it also distorts relative
prices, wages, and rates of return along the way.
Controlling Inflation
A country’s financial regulator shoulders the important responsibility of keeping
inflation in check. It is done by implementing measures through monetary policy,
which refers to the actions of a central bank or other committees that determine the
size and rate of growth of the money supply.
In the U.S., the Fed's monetary policy goals include moderate long-term interest
rates, price stability, and maximum employment. Each of these goals is intended to
promote a stable financial environment. The Federal Reserve clearly communicates
long-term inflation goals in order to keep a steady long-term rate of inflation, which
is thought to be beneficial to the economy.
Price stability—or a relatively constant level of inflation—allows businesses to plan
for the future since they know what to expect. The Fed believes that this will promote
maximum employment, which is determined by non-monetary factors that fluctuate
over time and are therefore subject to change. For this reason, the Fed doesn't set a
specific goal for maximum employment, and it is largely determined by employers'
assessments. Maximum employment does not mean zero unemployment, as at any
given time there is a certain level of volatility as people vacate and start new jobs.
Hyperinflation is often described as a period of inflation of 50% or more per month.
Monetary authorities also take exceptional measures in extreme conditions of the
economy.
Consequently, the U.S. policymakers have attempted to keep inflation steady at
around 2% per year.
Moreover, countries that are experiencing higher rates of growth can absorb higher
rates of inflation. India's target is around 4% (with an upper tolerance of 6% and a
lower tolerance of 2%), while Brazil aims for 3.5% (with an upper tolerance of 5%
and a lower tolerance of 2%).
Hedging Against Inflation
Stocks are considered to be the hedge against inflation, as the rise in stock prices is
inclusive of the effects of inflation. Since additions to the money supply in virtually
all modern economies occur as bank credit injections through the financial system,
much of the immediate effect on prices happens in financial assets that are priced in
their home currency, such as stocks. Gold is also considered to be a hedge against
inflation, although this doesn't always appear to be the case looking backward.
Extreme Examples of Inflation
Since all world currencies are fiat money, the money supply could increase rapidly
for political reasons, resulting in rapid price level increases. The most famous
example is the hyperinflation that struck the German Weimar Republic in the early
1920s.
The nations that were victorious in World War I demanded reparations from
Germany, which could not be paid in German paper currency, as this was of suspect
value due to government borrowing. Germany attempted to print paper notes, buy
foreign currency with them, and use that to pay their debts.
This policy led to the rapid devaluation of the German mark along with the
hyperinflation that accompanied the development. German consumers responded to
the cycle by trying to spend their money as fast as possible, understanding that it
would be worth less and less the longer they waited. More and more money flooded
the economy, and its value plummeted to the point where people would paper their
walls with practically worthless bills. Similar situations have occurred in Peru in
1990 and Zimbabwe between 2007 to 2008.
Why Is Inflation So High Right Now?
In 2022, inflation rates in the U.S. and around the world rose to their highest levels
since the early 1980s. While there is no single reason for this rapid rise in global
prices, a series of events worked together to boost inflation to such high levels.
The COVID-19 pandemic in early 2020 led to lockdowns and other restrictive
measures that greatly disrupted global supply chains, from factory closures to
bottlenecks at maritime ports. At the same time, governments issued stimulus checks
and increased unemployment benefits to help blunt the financial impact of these
measures on individuals and small businesses. When COVID vaccines became
widespread and the economy rapidly bounced back, demand (fueled in part by
stimulus money and low interest rates) quickly outpaced supply, which still
struggled to get back to pre-COVID levels.
Russia's unprovoked invasion of Ukraine in early 2022 led to a series of economic
sanctions and trade restrictions on Russia, limiting the world's supply of oil and gas
since Russia is a large producer of fossil fuels. At the same time, food prices rose as
Ukraine's large grain harvests could not be exported. As fuel and food prices rose, it
led to similar increases down the value chains.
What happens if Inflation goes out of control
Whether we see a repeat of the worst inflation levels in modern U.S. history (close
to 15% per year in the 1970s and post-WWII) or a milder version in the years to
come, it's safe to say the U.S. dollar will never devalue as fast as these 5 cautionary
tales from world history.
Known as "hyperinflation", unchecked, rampant inflation is about more than just
higher levels of currency money being printed or minted. It must also be combined
with an unwillingness of a nation's citizens to hold that money, for fear it may
quickly lose its value. This often comes as a result of unstable governments or wars.
Below are some of the most frightening examples of what can happen when a
national currency quickly becomes less valuable than the paper––or coin––it's
printed on.
1. Germany's 100 trillion Mark (1923): In 1923 the Weimar Republic of
Germany, which arose following World War I, defaulted on reparations
payments mandated by the Treaty of Versailles. There was also massive
political instability, a striking workforce, and military invasions from France
and Belgium. As a result, the republic started printing new money with great
speed, causing a massive devaluation of the mark. The exchange rate of
Marks/U.S. dollars rose from 9,000 to 4.2 Trillion (yes, with a "T") in less
than a year. Banknotes worth 1 million marks were followed by the issuance
of the 100 trillion Mark. The former lost their value so quickly and completely
that citizens began using the currency as notepads for writing, and even as
wallpaper!
2. Hungary's 100 quintillion pengo (1946) Hungary's hyperinflation bout
following WWII is considered one of the worst in history, resulting in the
issuance of the largest official banknote in history, the 100 quintillion (or 20
zeros after the one) pengo. To put the rate of inflation into perspective, the
price of goods in July 1946 Hungary was tripling every day.
You can see how when hyperinflation hits, people are literally afraid to hold
on to their money since it could easily be worthless tomorrow. This leads to a
panic of purchasing, which only furthers the negative feedback loop of faster
money flow and therefore higher rates of inflation.
3. Zimbabwe in 2008-09 The dubious honor of the first hyperinflation bout of
the 21st century belongs to Zimbabwe, which has already devalued (basically
knocking zeros off the currency in a one-time move) its currency four different
times this decade. The last official figures from the government put the annual
inflation rate at 231 million percent in 2007, but things have taken a turn for
the worse since. Tensions have escalated since Robert Mugabe kept himself
installed as the nation's leader despite losing the last "official" election in
2008. In May 2008 the Reserve Bank of Zimbabwe issued banknotes worth
500 million ZWD, which were worth less than 3 bucks in U.S. Dollars. There
were reports of citizens using plastic currencies because, by the time new
paper dollars are printed, they were already worthless.
Some workers were asking to be paid several times per day so they could run
out and spend their money before the currency lost even more value.
4. The U.S. Continental Currency And finally, one instance of hyperinflation
in the U.S. occurred during the Revolutionary War. In the days before the
Federal Reserve Bank and the U.S. dollar, the Continental Congress issued
new currencies to help fund the war efforts. But the Continental had no hard
backing and even changed in appearance from colony to colony, leading to
rampant counterfeiting, both by domestic citizens and groups who secretly
wanted to see the young nation fail in its attempt at independence.
The rapid devaluation of the fledgling currency gave rise to the term, "Not
worth a Continental", as the Continental saw rates of inflation exceeding
300% per year between 1777 and 1780. The founding fathers later realized
how vital it was to have a single central currency and even included clauses
in the founding documents requiring a silver or gold backing to the amount of
U.S. dollars issued into the economy.
Why it is important to have an accurate measure of inflation.
Inflation is a sustained rise in the general price level. Inflation statistics form the
basis of government policy, affect firms’ and individuals’ planning and are used to
set index linked wages, welfare benefits and interest rates. They are a means by
which the success of current policy can be judged and are of interest to citizens,
investors, trade unions, and official bodies.
Inflation is a central economic target. If the statistics are inaccurate the direction and
level of action may be inappropriate and may worsen the position. Lack of trust of
the statistics may undermine the acceptance of policies and their effectiveness.
Errors may be made in planning and real values may not be maintained.
Why might the figure be inaccurate?
• Inflation is measured by a weighted price index. This may be the consumer
price index, the retail price index or a variation of these. Each of the stages of
construction has problems.
• Choosing the base year needs a year with ‘normal’ conditions.
• The selection of a basket of goods needs to reflect average consumption
patterns and allow for the introduction of new products.
• Weighting the individual contents has to reflect up to date spending patterns.
• Sampling sales outlets must cover a wide enough range of types and locations.
• Even if these are achieved the average picture may not accurately reflect the
position of groups e.g. pensioners;
• It may not reflect changes in quality of goods;
• It may lag behind events and it may be based on inaccurate statistics and
invalid sampling.
Core Inflation
Most countries use CPI as a measure of headline inflation. Therefore, core inflation
measure in most countries are based on CPI. Although most evaluations of core
inflation measures do not include breadth as a criterion, some observers believe that,
in general, monetary policy should focus on a core.
How Is the CPI Basket Chosen?
In deciding which goods and services to include in the CPI basket and what their
weights should be, uses information about how much – and on what – households
spend their income. If households spend more of their income on one item, that item
will have a larger weight in the CPI. For example, we can include smart phones in
the CPI to reflect consumers taking advantage of advances in technology. Data on
household spending across all items is only available approximately every five years
or so.
Components of CPI Index
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https://www.mckinsey.com/featured-insights/inflation
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https://hispanicad.com/news/what-is-inflation
https://www.coursehero.com/file/p6mmkpjd/High-and-variable-rates-of-inflation-
can-impose-major-costs-on-an-economy
https://www.investopedia.com/financial-edge/0709/5-tales-of-out-of-control-
inflation.aspx
https://mrshearingeconomics.weebly.com/inflation.html
https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=13840
