You may have noticed the prices of your favorite products increasing. Sometimes, they increase quite a lot. The reason is the inflation impacting the economies of countries all around the world.
In this article, we will learn what inflation is, why it happens, what consequences it can have for average consumers, and what caused the inflation in 2022.
Summary
Inflation refers to the increase of prices of goods, which causes the population to buy less.
Inflation can be caused by high demand for certain products, increase in the prices of raw materials or fuel, currency devaluation, state policies, and other circumstances.
Low inflation can help the economy grow, while high inflation reduces the purchasing power of consumers and can lead to economic recession.
The global inflation that started in 2022 happened due to the aftermath of the COVID-19 pandemic and the geopolitical crisis in Ukraine.
What is inflation?
Inflation is an economic term used to describe a rise in the price of goods and services that causes the loss of purchasing power over time. Inflation is an important indicator as it shows how much the economy of a country has changed within a given period and whether or not the change affected the financial well-being of the country’s population.
Typically, inflation is expressed as a percentage demonstrating the rate of price increase within one year. Generally, inflation is calculated by a government agency that gathers and analyzes data about the current price of a certain basket of goods and services. This basket normally includes food, gas, clothing, medicine, energy, mortgage payments, etc. Its contents may vary depending on the volatility of a certain product’s price. The agency collects information about prices every month and then divides the average cost of the basket of goods by the cost of the same basket from the previous month.
The same basket of goods that cost $92.81 USD in October 2021, cost $100 by October 2022, indicating that the inflation had increased dramatically since the previous year.
Major causes of inflation
There are several major causes that can affect the rate of inflation.
High demand, low supply. When the population’s demand for certain goods and services increases too much, the economy might not have enough of them in supply. This puts an upward pressure on prices, causing inflation. An example of this would be the US baby formula shortage of 2022 when the general increase in prices and supply chain issues caused the prices of this essential product to skyrocket.
High cost, high price. When the costs of materials needed to produce the goods increase, so do the prices of those goods. For example, the 400% spike in the cost of lumber during COVID-19 caused the prices of houses to rise as well, resulting in a housing crisis that dominated the US real estate market.
Currency devaluation. When a country experiences currency devaluation, its exchange rate goes down, resulting in lower values for this currency. This is good news for other countries as buying the exports from this country is less expensive. But the population can no longer afford the goods imported from overseas, which encourages the citizens to buy domestic products.
Increased money supply. Money supply refers to the total amount of money circulating in the country, including cash, balances and bank accounts. If the money supply increases, it can lead to a shortage of products because the demand may overpower the supply of the goods.
Rising wages. When wages rise, the cost of labor increases as well, meaning that businesses have to adjust the price of the products to preserve their revenue. Besides, rising wages mean that the purchasing power of the population increases as well, causing the demand for certain goods to skyrocket and the prices to increase due to lack of supply.
State policies. Sometimes the government institutes policies and regulations that can cause the prices of the products to increase. Such policies can include tax subsidies and low interest rates, which causes consumers to buy more goods and drive up the prices.
Inflation: benefits and drawbacks
Inflation is not always bad. A low inflation rate (~2%) is actually a very good thing as it encourages people to buy more.
There are several benefits to inflation:
Economic growth. Inflation always happens when a country’s economy is on the rise. The increase in prices and wages helps businesses make more money, which drives the economy forward and prolongs the economic prosperity.
Wage adjustment. When the prices of goods go up, employees expect raises to battle their higher expenses. Businesses have to adjust the wages of their staff to ensure they don’t leave for a higher wage. This also helps employers encourage well-performing employees, creating a highly productive environment in their workplace.
Price adjustment. When people get more disposable income, they tend to buy more. This gives businesses an opportunity to adjust the price of their goods to reflect the increased demand, which allows them to make higher quality products for the consumers.
Reduces real value of debt. When prices and wages go up, the debt that people already have loses value. Governments also often incentivize lower interest rates, which helps their citizens deal with their debt.
Better than deflation. Deflation might occur if the value of a currency falls. This leads to a decrease in product prices because consumers may not be able to afford them otherwise. In the end, it may no longer be profitable to produce goods, which would lead to an economic standstill.
However, when inflation is high, it creates a lot of problems.
When wages aren’t adjusted to the increase in prices, people have to use their disposable income and savings to buy essential products. This decreases their potential to save and invest money, which slows down the economic growth of a country.
Higher inflation causes the prices of goods to increase. This makes that country’s products uncompetitive on the global market, which leads to fewer exports. Meanwhile, that country’s population struggles to afford those same goods.
Inflation can reduce the value of government bonds, causing investors to demand more compensation. The only way to satisfy that demand is to increase the debt interest for citizens, cutting into their purchasing power even more.
High inflation reduces the real incomes of households, which exacerbates income inequality and creates a bigger gap between the higher and lower income classes.
Inflation is hard to combat, and the measures governments decide to take can lead to short-term unemployment and even economic recession.