Inflation – Simply Explained

When economists speak about inflation, they usually mean price inflation, or the rate at which the cost of living in an economy goes up from year to year.

The concept is simple but how do you calculate inflation does inflation matter and what causes it?

To calculate the inflation rate economists first determine the typical basket of goods and services an average person buys, these include people spending on food, clothing, housing and everything else they consume, they then calculate the price of this basket, for example if in year one the basket cost 100 and in year two it cost 110, then the general price level in the economy has gone up by 10 percent.

This is what we mean by the inflation rate, or the change in the consumer price index. When economists calculate this it gets quite complicated since there are so many different items that we buy, and our basket of goods and services changes all the time.

An inflation rate of 10 percent seems high but if incomes rise at the same rate as the price level then people in the country as a whole are not worse off when inflation is high there are winners and losers imagine you have a lot of cash or you have a fixed income or pension, with high inflation the value of your money will drop quickly, as prices rise you will be able to buy fewer things with your money.

On the other hand if you have taken out a big loan, it will be easier to repay it if inflation is high since the money you need to pay back has decreased in value over time. Today most countries aim for an inflation rate somewhere between one and three percent, if inflation is very high it can get out of control and turn into hyperinflation , in this case prices rise at a faster and faster rate and people lose confidence in the currency this happened in Germany in the 1920s and in Venezuela in 2015.

If prices fall then there is negative inflation, also called deflation. It can be a big problem for an economy because people will postpone their purchases as they wait for prices to fall further.

the main cause of inflation is when the supply of money grows faster than the real output in an economy, with more money chasing the same quantity of goods, prices will increase, however there are circumstances when increasing the money supply does not cause inflation, for example when there is spare capacity or unemployment in an economy. The extra money can stimulate demand and grow the economy without causing inflation. Another cause of inflation is a supply shock, for example when oil prices rose quickly in 1973 everything became more expensive since so many products and services use oil as an input.

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