Understanding inflation: definition and mechanisms

Introduction: Why does inflation exist?

You have certainly noticed that your parents or grandparents talk to you about outdated prices. This perception is not an illusion: it reflects a fundamental economic phenomenon called inflation.

Inflation can be defined as the progressive erosion of the purchasing power of a given currency. It manifests itself as a widespread and lasting increase in the prices of goods and services within an economy. Unlike a simple price variation ( where only a few items become more expensive ), inflation affects the entire market and persists over time.

Understanding this dynamic is essential: why save your money if it is worth less each day? For this reason, governments and central banks are constantly trying to control inflation when it accelerates.

The Origins of Inflation

Essentially, two simple mechanisms explain inflation. First, a too rapid increase in the money supply in circulation. Historically, when European conquistadors massively brought gold and silver from the New World in the 15th century, bullion flooded into Europe, triggering significant inflation: the supply of money surpassed the real goods available.

Next, inflation occurs when the supply of a highly demanded good becomes insufficient. This scarcity drives prices up, an effect that gradually spreads to other economic sectors.

Three main forms of inflation

Demand-Pull Inflation

This is the most common type. It occurs when spending increases rapidly, exceeding the available supply. Imagine a baker who can produce 1,000 loaves of bread per week. His ovens and staff are operating at full capacity.

Now, if economic conditions improve and everyone has more money to spend, the demand for bread skyrockets. The baker cannot produce more immediately: it would take time to build new ovens and hire workers. Faced with this relative scarcity, some customers are willing to pay more to obtain bread. The price naturally rises. Multiply this scenario across all sectors (bread, milk, oil, clothing) and you get demand-pull inflation: the economy heats up, people buy more than the productive capacity can deliver.

Cost-Push Inflation

It emerges when production costs rise, prompting companies to increase their prices. Our baker has finally expanded his production to 4,000 loaves per week: supply meets demand. But now a poor wheat harvest creates a regional shortage. Wheat becomes scarce and costs much more. The baker has to pay more for his raw materials, so he raises his selling price, even though customers are not asking for more loaves.

Other factors cause this inflation: an increase in the minimum wage ( increasing labor costs ), a rise in government taxes, or the depreciation of the exchange rate ( making imports more expensive ). On a large scale, shortages of crucial resources such as wheat or oil trigger this form of inflation.

Embedded inflation

Also referred to as “hangover inflation,” it emerges from previous economic activity. If the two previous forms persist, they create inflationary expectations: employees and businesses expect future inflation and anticipate it.

Here is the mechanism: after years of inflation, workers negotiate salary increases to protect their purchasing power. Companies, faced with these higher wage costs, raise the prices of their products. This price-wage spiral is self-reinforcing: the higher the prices go, the more workers demand higher wages; the higher the wages increase, the more companies raise their prices. The perpetual cycle continues.

Mastering Inflation: Solutions

Uncontrolled inflation severely damages the economy, hence the importance of government interventions. Authorities have several levers at their disposal to combat it.

Increase interest rates

Central banks ( such as the U.S. Federal Reserve ) generally raise interest rates to curb inflation. Higher interest rates make borrowing expensive. Credit becomes less attractive for consumers and businesses, discouraging spending.

At the same time, saving becomes more profitable as the interest earned increases. Individuals and companies think twice before investing or spending on credit. Demand decreases, prices stabilize. However, this policy also slows down economic growth: if no one borrows or spends, economic activity shrinks.

Adjust the budget policy

Governments can also raise income taxes. With less disposable income, citizens buy less, reducing demand and theoretically inflation. But this approach carries political risks: tax increases provoke public hostility.

Quantitative tightening

Unlike quantitative easing (QE) that central banks use to inject liquidity during times of crisis, quantitative tightening (QT) reduces the money supply. Although theoretically effective against inflation, its practical application shows mixed results.

Measuring Inflation: The Price Index

To combat inflation, it is first necessary to measure it. Most countries use a Consumer Price Index (CPI). This index tracks the prices of a wide range of consumer goods purchased by households, using a weighted average to reflect the relative importance of each category.

Organizations like the U.S. Bureau of Labor Statistics collect this data from stores across the country to ensure accuracy. Suppose your CPI index is set at 100 during a “base year.” Two years later, if it reaches 110, it means that prices have increased by an average of 10%.

A slight inflation is not necessarily harmful. It is a natural phenomenon of modern monetary systems and even stimulates spending and investment. The important thing is to closely monitor this rate to prevent it from getting out of control.

Advantages and Disadvantages of Inflation

Inflation is not an absolute evil to be eradicated. It plays a role in contemporary economies and deserves a nuanced analysis.

The benefits of inflation

Moderate inflation encourages spending, investing, and borrowing. It is better to buy now than in a year when your money will have lost value. This outlook drives people and businesses to act quickly.

Businesses also benefit from this: they sell their products at high prices to protect themselves from the effects of inflation. If they justify these increases well, they can even pocket additional margins. Finally, a slight inflation is preferable to deflation (price drop). When prices fall, consumers hold off on purchases, hoping for future discounts. Demand collapses, unemployment rises, and the economy stagnates. Historically, deflationary phases have coincided with high unemployment rates and an excessive propensity to save rather than spend.

The risks of inflation

The main danger lies in hyperinflation, which occurs when prices increase by more than 50% in a month. A good that cost 10 dollars a few weeks ago suddenly costs 15 dollars. But it rarely stops there: prices regularly exceed this threshold, effectively destroying the currency and the economy.

High inflation also creates uncertainty. Individuals and businesses, unsure of where the economy is headed, become cautious and reduce their investments and spending, slowing down growth.

Finally, some critics oppose government interventions, arguing that the state “creates money” violates the principles of the free market and hinders natural economic laws.

Conclusion

Inflation is defined as a sustained increase in prices that gradually reduces purchasing power. It is a universal phenomenon that we have learned to accept. When properly managed, it benefits the economy by stimulating activity.

The most effective remedies seem to lie in a prudent dosage of flexible monetary and fiscal policies, allowing governments to adapt and contain inflationary pressures. However, these interventions require great vigilance: if poorly calibrated, they risk exacerbating economic damage rather than alleviating it.