Inflation: understanding its definition and economic mechanisms

Why Prices Are Rising: The Essentials of Inflation and Its Definition

You have probably noticed that your money doesn't buy as much as it used to. This is inflation at work. In simple terms, it represents the gradual decline in the purchasing power of a currency. More technically, it is a sustained and widespread increase in the prices of goods and services within an economy. Unlike one-time price variations, inflation is a phenomenon that extends across the entire market over a prolonged period.

The origins of inflation: two fundamental drivers

Basically, two main factors trigger inflation. The first is the excessive expansion of the money supply in circulation. Historically, during the European conquest of the Americas in the 15th century, the massive influx of gold and silver caused widespread inflation in Europe. The second factor lies in supply shortages of highly demanded products, leading to price increases that can spread throughout the economy.

Three categories of inflation: understanding the variations

The economist Robert J. Gordon identified three main forms of inflation, categorized according to the “triangular model.” Each has its distinct characteristics.

Demand-pull inflation

When consumers and businesses significantly increase their spending, demand outstrips available supply. Take the example of a bakery producing 1,000 loaves of bread weekly. If economic conditions improve and customers suddenly flock in, demand exceeds production capacity. Unable to quickly ramp up production (, which takes time, personnel, and additional equipment ), the baker raises his prices. This phenomenon extends across all sectors: food, energy, services. Consumers with more income buy more, thus creating widespread demand-driven inflation.

Inflation caused by the increase in production costs

This type of inflation works differently. Even without an increase in demand, prices rise due to higher production costs. Let's return to our example: after increasing his capacity to 4,000 loaves per week, the baker receives bad news. A poor wheat harvest drastically reduces the regional supply. Forced to pay more to obtain his raw material, he must raise the price of his products to maintain his margins. Similarly, an increase in the minimum wage or a rise in government taxes directly impacts consumer prices. On a macroeconomic scale, shortages of essential resources, unfavorable exchange rate fluctuations, or additional taxes cause this type of inflation.

Persistent inflation: the effect of expectations

Embedded inflation, sometimes referred to as “hangover inflation”, results from prior economic activity. It feeds itself through two mechanisms. First, individuals and businesses expect inflation to continue, basing their decisions on this forecast. Then, a price-wage spiral establishes itself: employees demand wage increases to preserve their purchasing power, which prompts companies to raise the prices of their products, creating a self-sustaining cycle that is difficult to break.

How to Master Inflation: Available Tools

Uncontrolled inflation threatens economic stability. Monetary authorities have several levers at their disposal to contain it.

Increase interest rates

This is the most commonly used method by central banks. Higher interest rates make borrowing expensive, discouraging consumers and businesses from taking out loans. This measure slows down spending and investment, thereby reducing overall demand and, by extension, inflation. However, it can also slow down economic growth as economic agents become more cautious.

Adjust the state's budget policy

Governments can also increase income taxes, thereby reducing households' purchasing power and demand in the market. This approach carries political risks, as the public generally reacts negatively to tax increases. Alternatively, governments can cut their spending, which also helps to curb inflation.

Modify the money supply

Central banks control the supply of fiat money. Quantitative easing (QE) involves injecting fresh money into the economy, which can exacerbate inflation. In contrast, quantitative tightening (QT) reduces the money supply, but its effectiveness remains limited.

Measuring Inflation: The Price Index

Before combating inflation, it must be measured. Most countries use a Consumer Price Index (CPI), which tracks the prices of a representative basket of goods and services purchased by households. Organizations such as the U.S. Bureau of Labor Statistics collect this data from businesses to ensure accuracy.

If the CPI is set at 100 in the base year and reaches 110 two years later, it means that prices have increased by 10% over that period. Low inflation is natural in modern economies and can even be beneficial, stimulating spending and borrowing.

The two sides of inflation: advantages and risks

Benefits of moderate inflation

Controlled inflation encourages immediate spending, as holding cash becomes less attractive. Businesses benefit from an increased margin to justify price increases. Furthermore, moderate inflation is preferable to deflation, which discourages purchases and slows down economic growth.

Dangers of uncontrolled inflation

If inflation accelerates dangerously, it becomes destructive. Hyperinflation, where prices rise by more than 50% in a month, completely erodes the value of the currency. High inflation also creates uncertainty: households and businesses become cautious, reducing investment and growth. Some also criticize government interventionism, arguing that the ability of states to “create money” violates the natural principles of the market economy.

Conclusion: balance and vigilance are necessary

Inflation is an unavoidable phenomenon of modern economies. Well understood and properly regulated, it can support growth. But it requires constant monitoring. Monetary and fiscal policies must be calibrated carefully: too much intervention creates other problems, while a lack of control leads to economic chaos. Finding this balance remains the central challenge for contemporary economic decision-makers.