Inflation

What is inflation?

We often hear this familiar word in daily news and broadcasts. Inflation has plunged countries into long periods of instability, and it was declared Public Enemy No.1 in the United States – by President Gerald Ford in 1974. What, then, is inflation and why is it so important?

Inflation is when prices of just about everything go up over a given period of time. The term is typically a broad measure such as an increase in the cost of living in a country. But it can also be more narrowly calculated for certain items such as foods or services. Whatever the context is, inflation represents how much more expensive the relevant set of products or service categories has become over a certain period, most commonly a year.

Causes of inflation

There are several key causes of inflation, which can be generally grouped into three categories:

• Demand-pull

• Cost-push

• Inflation expectations

Adopt image from Link

Demand-pull inflation

This occurs when the total demand for goods and services (also referred to as ‘aggregate demand’) exceeds the economy’s ability to supply them. As demand outpaces supply, businesses respond by raising prices.

Adopt image from Link

The flow starts with an increase in aggregate demand due to a number of reasons:

• An increase in spending by consumers;

• An increase in spending by businesses or government or;

• An increase in net exports.

To meet the extra demand for goods and services, firms increase the output by seeking to employ more workers. With a tight labour market, firms have to offer higher wages to attract new staff and retain their existing employees at the same time. As a result, firms will factor the incremental increase in labour cost into product prices. More jobs and higher wages lead to an increase in household incomes, lift consumer spending and further increase aggregate demand. When the cycle repeats and happens across a large number of businesses and sectors, this causes an increase in inflation.

Cost-push inflation

This arises when the costs of production for goods and services increase, leading producers to raise prices to maintain profitability. Cost-push inflation occurs due to:

• Rising wages: When labour costs increase, businesses may pass these costs onto consumers through higher prices.

• Increased cost of raw materials: A rise in the price of essential inputs like oil, gas, or metals increases production costs.

• Supply chain disruptions: Natural disasters, geopolitical tensions, or pandemics can disrupt supply chains, reducing supply and pushing up prices.

• Currency depreciation: When a country’s currency depreciates, the cost of imports rises, contributing to inflation.

Inflation expectations

Inflation expectations refer to the beliefs held by the public and businesses about future price increases. These expectations play a crucial role in shaping actual inflation because they influence the behaviour of consumers, businesses, and policymakers.

In some circumstances, if workers expect prices to increase in future, they may request higher wages to maintain their purchasing power. Firms may agree to higher wage demands and pass on these costs to consumers when they buy goods and services. This leads to a wage-price spiral, in which rising wages push prices higher, contributing to inflation.

Similarly, if consumers expect inflation to rise, people may begin hoarding goods and making large purchases to avoid paying higher prices in the future. This increased demand can cause actual prices to rise, contributing to a higher rate of inflation.

Anchored and Unanchored inflation expectations

Source: Reserve Bank of Australia (RBA)

The impacts of inflation

In reality, prices change frequently at different paces, while wages established by contracts are stickier and take longer to adjust. To the extent that a rise in households’ nominal income cannot catch up with unevenly rising prices, it will inevitably reduce the consumer purchasing power. They are worse off because they can afford to purchase less.

On the other hand, a borrower who pays a fixed mortgage rate would benefit from inflation as the real interest rate (nominal rate minus inflation) would be reduced. Servicing debt would be at ease if inflation is higher, as long as the borrower’s income keeps up with inflation.

High inflation also hurts an economy with many countries grappling with hyperinflation. In 2009, Zimbabwe faced the worst case of hyperinflation of over 500 billion per cent annually. The country had to take difficult and painful policy to bring inflation back to reasonable levels, involving abandoning the Zimbabwean dollar and adopting foreign currencies to stabilise the economy.  

How is inflation measured?

The most well-known indicator of inflation is the Consumer Price Index (CPI) which measures the rate of change in the prices of a basket of household goods and services at a given time expressed relative to a base year. For instance, if the base year CPI is 100 and the current CPI is 110, inflation is 10% over the period.

To measure the CPI, government agencies of a country survey to identify the most commonly purchased items and track over time the cost of purchasing this basket. Generally, housing expenses including rent and mortgages make up the largest component in the CPI basket for most nations.

Source: Reserve Bank of Australia

Core consumer inflation (CPI)

Core consumer inflation is mostly used and closely watched by policymakers, at which it focuses on the underlying and persistent trends in inflation by excluding prices of food and energy sectors because their prices are much more volatile and fluctuate wildly.

• Food and energy are necessities and inelastic products as demand for them won’t change much even when the prices rise. For instance, fuel prices may increase but you still need to fill up the tank to drive up your car.

• In addition, these commodity items may have large price changes due to temporary factors, which are unrelated to broad conditions in the economy. For example, in 2006, a Tropical Cyclone destroyed crops of banana in Queensland Australia, which led to a decrease in banana supply and temporarily increased prices by 400%.

Limitations of the CPI

CPI is not an indicator of the price level

Let’s say, for example, the price index of bread is 140 and the price index of eggs is 180. It does not mean that eggs are more expensive than bread. It only means that the price of eggs has increased by more than the price of bread from a particular point in time.

The coverage

For practical reasons, the CPI measured by a country’s government agencies might not cover price changes in regional, rural and remote areas. Moreover, it does not reflect the spending patterns among individual households since some spend a lot more on certain items than others.

Quality changes

The CPI only calculates pure price changes and ignores those results from variations in the quality of items in the basket. For example, the price of a mobile phone increases because of the better camera or price of checkups increases due to improved x-ray technology.

Substitution bias

In practice, the CPI does not adjust changes in household spending patterns very often, therefore, it is affected by ‘substitution bias’. For instance, if lamb prices rise more than beef prices, consumers might switch to beef and spend less on lamb. However, the CPI might not adjust timely for this type of substitution in expenditure, given too much weight of lamb in the CPI basket rather than beef.

New products

The CPI does not include new products as soon as they appear on the market. Instead, it will take some time to add them to the CPI basket. This typically occurs once a product has reached a high enough market share and is available to most households.

References 

Brown, T & Foreman, C 2022, UH Macroeconomics 2022, OpenStax, Houston, TX, pp. 323-391.

McKinsey & Company 2024, What is inflation?, McKinsey & Company, available at <https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-inflation>.

Reserve Bank of Australia n.d., Inflation, Reserve Bank of Australia, available at <https://www.rba.gov.au/inflation-overview.html>.

Reserve Bank of Australia n.d., Causes of Inflation, Reserve Bank of Australia, available at <https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html>.

Standford Report 2022, What causes inflation? Stanford scholar explains, Standford Report, available at <https://news.stanford.edu/stories/2022/09/what-causes-inflation>.