What Is Inflation?
Updated: Apr 12, 2021
Inflation may occur because of decisions made for the economy as a whole, but it is very capable of affecting our everyday lives. Balancing inflation is one of the biggest challenges that an economy faces. However, in order to face this dilemma, we must understand what inflation exactly is.
Before you begin reading, I would suggest reading this article on supply and demand first since supply and demand correlate with inflation.
What Is Inflation
Inflation is the increase in prices of goods and services over time. This means that people can buy less goods or services with the money they have, and the purchasing power of money has decreased. Basically, inflation causes money to be less valuable.
There are two types of inflation: cost-push inflation and demand-pull inflation. The main difference between the two is what causes each to occur. Cost-push inflation is caused by increased production costs and inputs. Since producers need to contribute more resources to produce, they will raise prices in order to cover the costs of production. Demand-pull inflation is caused by increased demand for goods and services. As more and more consumers want to consume a good, producers are given a reason to increase prices.
Inflation can be measured by using a consumer price index (CPI). A CPI measures the changes in prices of goods in a market basket over a few years. A market basket is a collection of goods (i.e. 1 pound of apples and 2 pounds of bananas). CPIs are one of the most common forms of measuring inflation.
A CPI works by creating an index, or base unit/price, for a base year. The CPI for the base year is always 100. I like to think of this as representing 100% of prices. From there, we need to find the CPI of another year. We can do that through this formula:
(price of market basket in year / price of market basket in base year) x 100
From there, we compare the two indices to determine the inflation rate. For instance, the 2020 (base year) index is 100 and the 2021 index is 150. If we were to subtract the 2020 index from the 2021 index, we would get a difference of 50. Therefore, the inflation rate for this example is 50%.
This may be confusing at first, so if you want to explore CPIs a little more, check out this YouTube video I made here.
Inflation In The Economy
Inflation is inevitable in every economy, but it is not always a bad thing. Inflation can be a result of increased economic activity which is very good for an economy and businesses. According to the Federal Reserve website, it is widely accepted that a 2% inflation rate is considered "healthy".
Although some inflation is good, too much can be catastrophic for an economy. If an economy is doing very poorly at the moment, inflation will make the situation much, much worse. Economists refer to this situation as stagflation (stagnate economy + inflation). Stagflation is basically a combination of low economic activity and high inflation rates.
Before we end, I want to give a shoutout to my economics teacher for teaching me a lot of this information.
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Board Of Governors Of The Federal Reserve System 2011, Federal Reserve, accessed 15 March 2021, <https://www.federalreserve.gov/faqs/5D58E72F066A4DBDA80BBA659C55F774.htm>