Understanding inflation: mechanisms, impacts, and solutions

Why did your grandparents find everything cheaper?

Inflation is the economic phenomenon that gradually makes your money less powerful. What your grandmother could buy for 10 euros 30 years ago now costs much more. Behind this reality lie complex mechanisms that we will explore in detail.

Definition and Fundamental Issues

Inflation represents the gradual decrease in the purchasing power of a currency. It is a sustained and widespread increase in the prices of goods and services in a given economy. Unlike simple isolated price variations when only one product becomes more expensive, inflation affects nearly all sectors simultaneously over an extended period.

Governments generally measure inflation on an annual basis, expressing it as a percentage to facilitate comparisons from one year to the next. This constant vigilance is justified: poorly managed inflation can cause significant damage to the economy and the daily lives of citizens.

Two major vectors of inflation

( The explosion of the money supply

The primary cause of inflation lies in a rapid increase in the amount of money in circulation. A historical example illustrates this perfectly: in the 15th century, the massive influx of gold and silver from the New World flooded European markets. This abundance of precious metals directly caused a widespread rise in prices – sellers adjusted their rates in response to an excessive money supply.

) The scarcity that drives up prices

The second major vector of inflation arises from an inverse scenario: when a highly demanded good becomes scarce. Imagine a catastrophic wheat harvest. Farmers can produce only half of their usual volume, while demand remains unchanged. Bread prices soar. This increase then spreads to other sectors: if bakers spend more on their raw materials, their other operating costs follow the same trajectory.

The three forms of the cause of inflation

Demand-pull inflation: too many buyers, not enough products

Demand-pull inflation occurs when spending increases faster than production. Imagine a bakery capable of producing 1,000 loaves of bread per week. Its facilities are running at full capacity and it regularly sells out its stock.

Now let's suppose that the economic situation improves. Consumers have higher incomes and buy more. The demand for bread rises to 1,500 units per week, but our baker can still only produce 1,000. His customers are willing to pay more to secure their purchase, so he raises his prices.

Multiply this phenomenon by hundreds of sectors – milk, oil, services – and you get a generalized demand-driven inflation.

Cost-push inflation: when production becomes expensive

This type of inflation occurs when production costs rise without any change in demand. Our baker has finally invested: new ovens, additional staff, capacity increased to 4,000 loaves per week. Everything is working perfectly.

But one morning, bad surprise: a drought has devastated the regional crops. Wheat is severely lacking. Our baker has no choice but to pay more to obtain his raw material. He raises his selling prices accordingly, even without an increase in demand.

Other common examples: an increase in the minimum wage raises the labor costs for businesses. New government taxes reduce profit margins. The weakening of the local currency makes imports prohibitive. All these factors pass their impacts onto the final consumer.

Embedded inflation: when the past shapes the present

Embedded inflation ###sometimes referred to as hangover inflation### is generated by previous economic activity. It emerges when demand or cost inflation persists for a long time.

Economic actors – workers, businesses, investors – then develop inflationary expectations: they anticipate that prices will continue to rise. Employees negotiate salary increases to compensate for the expected erosion of purchasing power. Businesses raise their prices as a precaution. This price-wage spiral becomes self-reinforcing: cost increases justify new wage demands, which in turn justify new price hikes.

The virtues and vices of inflation

( The positive aspects

Encouraging spending and investments

Low inflation encourages households and businesses to act quickly. Why wait to buy a house or invest in equipment if your money will lose 2% of its value each year? This relative urgency stimulates economic activity.

Improve profit margins

Companies that pass on inflation in their prices potentially see their margins widen. If costs increase by 3% but they raise prices by 5%, profits become more generous – as long as the market accepts these new prices.

Preferable to deflation

Deflation – a lasting decline in prices – seems attractive at first glance. But it creates a psychological trap: if prices are going to drop tomorrow, why buy today? Consumers constantly postpone their purchases. The economy stagnates, businesses reduce production, and unemployment rises. Historically, deflationary periods have always coincided with severe economic recessions.

) The dangers of inflation

Progressive monetary erosion

One euro spent today is worth more than one euro spent in five years. This inevitable devaluation penalizes those who hoard cash. Your savings under the mattress gradually lose their purchasing power. For small savers without access to interest-bearing investments, this is a form of silent theft.

Hyperinflation: The Point of No Return

When inflation exceeds 50% in a month, it is referred to as hyperinflation. Prices do not simply double – they can increase tenfold in a matter of weeks. The price of a necessity can go from 10 euros to 150 euros in two months. Currencies lose all credibility, people abandon fiat money for foreign currencies or barter. The economy practically collapses.

Paralyzing uncertainty

When inflation becomes erratic and high, no one knows how to plan for the future. Businesses hesitate to invest in new projects. Households tighten their belts. This collective caution slows economic growth and can even push it into recession.

How to measure inflation?

The first step in combating inflation is to measure it accurately. Most modern nations use a consumer price index ###CPI### as a reference.

The CPI takes a representative basket of goods and services that households regularly purchase – food, housing, transportation, leisure. This set is weighted to reflect the actual spending habits of consumers. Statistical agencies ( such as the Bureau of Labor Statistics in the United States) collect prices at thousands of retail outlets to ensure the accuracy of the calculations.

The calculation works like this: we set a base year (score IPC = 100). If two years later, the same basket of goods costs 110, it means that prices have increased by 10% over two years. Simple, but terribly effective for monitoring trends.

How Governments Combat Inflation

When inflation becomes too vigorous, it threatens economic stability. Governments have several tools at their disposal to curb it.

( Increase interest rates

Most central banks )Federal Reserve, European Central Bank, etc.### use interest rates as the main anti-inflationary lever.

Higher rates make borrowing more expensive. For consumers: a mortgage of 300,000 euros costs much more in interest. They think twice before borrowing. For businesses: investing requires a higher profitability. In both cases, spending decreases, demand weakens, and prices stop rising.

At the same time, saving becomes attractive: putting your money at 4% interest suddenly seems worthwhile. Households are increasing their savings rate, which further reduces demand.

( Modify the tax policy

Some governments complement the action of central banks by modifying fiscal policy – that is, taxes and public spending.

Increasing income taxes on households leaves less money available for consumption. Reducing public spending can also decrease overall demand. These approaches are politically sensitive )tax increases are unpopular###, but they can be effective when inflation is running high.

( The role of the money supply

Central banks also directly control the amount of money in circulation. Quantitative easing )QE### injects new money into the economy – a measure generally used in times of recession. Conversely, quantitative tightening (QT) reduces the money supply by gradually removing money from the system. However, QT has proven to be less effective than raising rates to combat inflation.

Conclusion: a delicate equation

Inflation is not the enemy to be completely eradicated – it is an integral part of modern economies that use fiat currency. A low and stable inflation rate around 2% per year is even considered healthy: it encourages spending rather than hoarding cash.

The real challenge lies in control and balance. Governments and central banks must navigate carefully to maintain moderate inflation without tipping into inflationary chaos or sinking into deflation. The tools exist – rigorous monetary policies, appropriate taxation, close monitoring of price indices – but their implementation requires expertise, precise timing, and great caution.

Economic history shows that neglecting inflation risks long-lasting damage. However, combating it clumsily can create other problems. That is why, from central banks to finance ministries, so many professionals scrutinize these figures daily with meticulous attention.