What is inflation? And what causes it?

Inflation is the continuous variation in the prices of goods and services over time, affecting everything from essential items like housing, food, and healthcare to non-essential products such as cosmetics and automobiles. In other words, this economic concept measures how much a set of goods and services has become more expensive over a given period.

The main indicator of this phenomenon is the Consumer Price Index (CPI), which measures the percentage change in the prices of a basket of goods consumed by households. The CPI is calculated by statistical agencies, such as the Australian Bureau of Statistics, which collects prices for thousands of items.

Inflation is caused by the gradual rise in prices of goods and services across the entire economy. While controlled inflation is necessary for economic growth, high levels of inflation can lead to serious issues, such as the loss of purchasing power.

The expectation that prices will continue to rise leads consumers and businesses to adjust their behavior, making inflation a constant concern in the economic landscape.

In summary, inflation is nothing more than generalized price changes throughout the economy. To measure inflation, statistical agencies collect data on the current prices of various goods and services and compare them with the prices of the same items in the past.

Deflation

Unlike inflation, which is associated with rising prices, deflation is the decrease in prices in a specific sector or the entire economy. While it may seem positive, deflation can be dangerous, as it leads consumers to delay purchases, which slows down economic growth, reduces wages, and stalls the economy.

What causes inflation?

We know that any increase in the prices of goods or services affects your wallet. But what causes inflation? Let’s take a look at the main factors.

Inflation is a natural consequence of the use and exploitation of goods and services because it is linked to several factors. The increase in production costs associated with raw materials or labor, and higher demand, can lead to inflation.

Certain fiscal and monetary policies, such as tax cuts or lower interest rates, are also potential factors.

Additionally, temporary changes in inflation can be caused by events like supply disruptions or seasonal sales, while persistent changes arise from factors like sustained wage growth across the community.

In summary, this gradual increase in prices associated with inflation can be caused in two main ways: demand-pull inflation and cost-push inflation. Both relate to fundamental economic principles of supply and demand. More broadly, other potential causes of inflation may include:

• Built-in inflation.
• Real estate market.
• Expansionary monetary and fiscal policy.
• Currency depreciation.

Thus, inflation:

• Measures the rate of increase in the prices of goods and services in an economy.
• Can occur due to rising production costs, such as raw materials and wages.
• Growth in demand for products and services can cause inflation, as consumers are willing to pay more.

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Cost-push inflation

Cost-push inflation occurs when prices rise due to increasing production costs, such as raw materials or wages. This increase is passed on to consumers, raising product prices, even without a rise in demand.

Demand-pull inflation

Demand-pull inflation happens when there is a strong demand for products or services, outpacing supply. The result is higher prices, driven by consumers’ willingness to pay more for scarce items.

Built-in inflation and wage increases

Built-in inflation arises when people expect prices to continue rising and demand higher wages to keep up with inflation. This creates a cycle of wage and price increases, as businesses pass higher costs on to consumers.

Real estate market

The real estate market is sensitive to demand. When the economy is expanding and the demand for homes increases, house prices and construction material costs also rise, impacting the overall cost of living.

Expansionary fiscal and monetary policy

Expansionary fiscal and monetary policies, such as tax cuts or interest rate reductions, stimulate the economy by increasing disposable income for consumers and businesses, which raises demand and may lead to inflation.

Currency depreciation

Currency depreciation happens when the money supply grows rapidly, decreasing its value and driving prices up. This occurs because there is more money circulating than goods available for purchase.

Inflation measures

To understand how inflation works or fluctuates and how this indicator is measured, some additional indicators are generally used to measure inflation:

• Consumer Price Index (CPI): Measures the price variation of a basket of goods and services, such as food and transportation, to track inflation from the consumer’s perspective.
• Producer Price Index (PPI): Measures price changes from the producers’ perspective, reflecting the cost of inputs like fuel and raw materials.
• GDP Deflator: Evaluates the prices of all goods and services produced nationally, serving as a comprehensive measure of inflation.
• Personal Consumption Expenditures (PCE) Price Index: Tracks price changes based on spending on consumer goods and services, offering a broader measure than the CPI.

How to protect your finances during inflation

Some ways to protect your finances against inflation include securing loans with fixed rates, investing in stocks and inflation-adjusted bonds, saving with high interest rates, and acquiring assets that act as a hedge, such as gold or real estate.