What is Inflation

Definition of Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. Central banks attempt to limit inflation—and avoid deflation—in order to keep the economy running smoothly.

Formulas for Measuring Inflation

1. Consumer Price Index (CPI)

The Consumer Price Index measures the average change in prices over time that consumers pay for a basket of goods and services.

            
                CPI = (Cost of Market Basket in Current Year / Cost of Market Basket in Base Year) × 100
            
        

Example:

            
                If the cost of a market basket in the base year is $500 and in the current year is $550, the CPI is calculated as:
                CPI = (550 / 500) × 100 = 110
            
        

2. Inflation Rate Using CPI

The inflation rate can be calculated by comparing the CPI of two different years.

            
                Inflation Rate = ((CPI_Current Year - CPI_Previous Year) / CPI_Previous Year) × 100
            
        

Example:

            
                If the CPI in 2022 was 110 and in 2023 it was 115, the inflation rate is:
                Inflation Rate = ((115 - 110) / 110) × 100 = 4.55%
            
        

3. Producer Price Index (PPI)

The Producer Price Index measures the average change over time in the selling prices received by domestic producers for their output.

            
                PPI = (Cost of Basket of Goods in Current Year / Cost of Basket of Goods in Base Year) × 100
            
        

4. GDP Deflator

The GDP Deflator is a measure of the price level of all domestically produced final goods and services in an economy.

            
                GDP Deflator = (Nominal GDP / Real GDP) × 100
            
        

Example:

            
                If the nominal GDP is $1,100 billion and the real GDP is $1,000 billion, the GDP deflator is:
                GDP Deflator = (1100 / 1000) × 100 = 110
            
        

5. Personal Consumption Expenditures (PCE) Price Index

The PCE Price Index measures the prices paid by consumers for goods and services.

            
                PCE Price Index = (Value of Goods and Services at Current Prices / Value of Goods and Services at Base Year Prices) × 100
            
        

Example:

            
                If the value of goods and services at current prices is $1050 and at base year prices is $1000, the PCE Price Index is:
                PCE Price Index = (1050 / 1000) × 100 = 105
            
        

Example Table

Calculations:

            
                1. CPI for 2022:
                CPI_2022 = (550 / 500) × 100 = 110

                2. Inflation Rate for 2022:
                Inflation Rate_2022 = ((110 - 100) / 100) × 100 = 10.0%

                3. CPI for 2023:
                CPI_2023 = (605 / 550) × 100 = 121

                4. Inflation Rate for 2023:
                Inflation Rate_2023 = ((121 - 110) / 110) × 100 = 10.0%
            
        

1. Demand-Pull Inflation

Occurs when the demand for goods and services exceeds their supply.

Often described as "too much money chasing too few goods."

Example: During economic booms, increased consumer spending can lead to demand-pull inflation.

2. Cost-Push Inflation

Results from an increase in the cost of production.

Causes the supply of goods to decrease while the demand remains constant.

Example: A significant rise in oil prices can lead to higher transportation and production costs, causing cost-push inflation.

3. Built-In Inflation

Also known as wage-price inflation.

Occurs when workers demand higher wages to keep up with rising living costs, which in turn leads businesses to raise prices to cover the increased labor costs.

Example: If workers negotiate higher wages, companies may increase prices to maintain profit margins, creating a cycle of rising wages and prices.

4. Hyperinflation

Extremely high and typically accelerating inflation.

Often results from a rapid increase in the money supply without a corresponding increase in goods and services.

Example: Post-World War I Germany experienced hyperinflation, where prices soared uncontrollably, and the currency lost almost all its value.

5. Stagflation

A combination of stagnant economic growth, high unemployment, and high inflation.

It is challenging for policymakers because measures to reduce inflation may worsen unemployment, and measures to reduce unemployment may increase inflation.

Example: The 1970s oil crisis led to stagflation in many Western economies, combining slow growth and high inflation.

6. Deflation

The opposite of inflation, where the general price level of goods and services decreases.

While not a type of inflation, it is important to understand in the context of inflationary pressures.

Example: During the Great Depression, deflation occurred as demand fell dramatically, leading to lower prices and economic stagnation.

Visual Representation

Skewflation

Skewflation refers to the situation where price levels increase in some sectors while remaining stable or decreasing in others. This can distort the overall measure of inflation since the aggregate inflation rate might not accurately reflect the price changes experienced by consumers in different sectors.

Example: If healthcare costs and education fees rise significantly, but the prices of electronics and clothing remain the same or drop, the overall inflation rate might appear moderate. However, consumers heavily reliant on healthcare and education would experience higher inflation in their personal expenses.

Reflation

Reflation is the process of boosting the level of economic activity and inflation to a long-term trend after a period of deflation or low inflation. It involves the use of fiscal or monetary policy to increase the money supply, stimulate demand, and raise prices.

Example: After the 2008 financial crisis, many governments and central banks used reflationary policies, such as lowering interest rates and increasing public spending, to revive economic growth and combat deflationary pressures.

Disinflation

Disinflation refers to a slowdown in the rate of inflation – a decrease in the rate at which prices are rising. It is different from deflation, where prices actually decrease. Disinflation indicates that the inflation rate is declining, but prices are still rising, just at a slower pace.

Example: If the inflation rate falls from 5% to 3%, it is considered disinflation. Prices are still increasing, but the rate of increase has slowed.

Phillips Curve

The Phillips Curve represents the inverse relationship between the rate of inflation and the rate of unemployment. According to the Phillips Curve, when unemployment is low, inflation tends to be higher because more people have jobs and income to spend, driving up demand and prices. Conversely, when unemployment is high, inflation tends to be lower due to reduced consumer spending.

Phillips Curve Formula:

There is no single formula for the Phillips Curve, but it can be represented graphically. The general relationship can be summarized as:

            
                Inflation Rate = f(Unemployment Rate)
            
        

Example:

            
                - Low unemployment (e.g., 3%) may correspond to high inflation (e.g., 6%).
                - High unemployment (e.g., 8%) may correspond to low inflation (e.g., 2%).
            
        

Visual Representation