Dynamics of inflation
Many countries, including Venezuela and recently Lebanon, have seen the purchasing power of their currency decline over time. But what is inflation ? What are its causes and effects?
1. What is inflation? And what causes it?
Inflation is the gradual loss of a currency’s purchasing power over time. The increase in the average price level of a basket of selected goods and services in an economy over time can be used to calculate a quantitative measure of the rate at which purchasing power declines. Often expressed as a percentage, this increase underlines that a unit of money is being purchased less than in previous periods.
If a currency’s value falls, prices increase, and less goods and services can be purchased. This loss is reflected in the general cost of living, which in turn causes economic growth to slow down. Various factors can cause price or inflation in an economy.
When prices rise as a result of rising manufacturing costs, such as raw materials and wages, this is known as cost-push inflation. The demand for products remains constant, although the supply of goods decreases as production costs rise. As a result, the increased manufacturing costs are passed on to customers in the form of higher finished goods prices.
Strong market demand for a product or service can lead to demand-pull inflation. Demand-pull inflation occurs when a boom in demand for commodities occurs across an economy, causing prices to rise. When unemployment is low and incomes are increasing, consumer morale is high, which leads to increased spending. Economic growth has a direct effect on consumer spending in a given economy, which can lead to a surge in product and service demand.
Expansionary fiscal policy
Governments will increase the amount of disposable income for both companies and consumers by enacting expansionary fiscal policies. Businesses can spend tax cuts on capital projects, employee benefits, or new jobs if the government lowers taxes. Additionally, consumers will have the opportunity to obtain more goods. Increased government spending on infrastructure projects may also help to improve the economy. As a consequence, demand for goods and services may grow, resulting in price increases.
2. The common effects of inflation
Inflation is a topic that is often linked to a struggling economy. While this idea is not necessarily wrong, it is not always true either. Inflation can also be seen as a sign of a thriving economy, although this may seem strange at first.
So let’s take a closer look at the effects of inflation on the economy to better understand this phenomenon.
Inflation worsens purchasing power
This first effect is part of the definition of inflation: A change in the price of a specific product is not considered inflation since only people who buy this product on a regular basis will experience a depreciation of their overall purchasing power.
For inflation to occur, the prices of goods and services in a “basket” must increase. The Consumer Price Index (CPI) is used to measure price changes. Some essential, non-replaceable items such as food and fuel can have a direct impact on inflation when their prices rise.
A banana that costs 362 ZIM dollars
Inflation encourages spending and investment
As cash continues to lose value, the natural response is to avoid saving by spending on things that will not lose value. So businesses make capital investments.
So how do you take advantage of inflation?
Over the long term, stocks have been among the best shelters for inflation. In 1980, a share of Apple Inc cost $29 in current dollars (not adjusted for inflation). In 2018, that figure is $7,035 or the equivalent of $2,438 in 1980 dollars which implies a real inflation-adjusted gain of 8,346%.
Inflation causes more inflation
As consumers and businesses begin to avoid saving their depreciating currencies and begin to spend that money on just about anything to avoid holding on to money that has no value, the economy is flooded with unwanted liquidity. Thus supply exceeds demand and the value of money decreases, which in turn stimulates inflation and creates a feedback loop that can have catastrophic consequences, including hyperinflation.
Drop of the Libanese pound (2020)
Inflation reduces unemployment
There is an inverse correlation between unemployment and inflation. For an employer, an increase in inflation means a decrease in real wage costs which allows him to hire more employees.
The relationship between unemployment and inflation is known as the Philips curve.
Floyd, D. (2021, January 22). 9 common effects of inflation. Retrieved March 26, 2021, from https://www.investopedia.com/articles/insights/122016/9-common-effects-inflation.asp
Fernando, J. (2020, March 18) Inflation. Retrieved March 19, 2021, from https://www.investopedia.com/terms/i/inflation.asp
Investopedia (2020, April 13) What Causes Inflation and Who Profits From It? Retrieved March 19, 2021, from https://www.investopedia.com/ask/answers/111314/what-causes-inflation-and-does-anyone-gain-it.asp#:~:text=Key%20Takeaways-,Inflation%20is%20a%20measure%20of%20the%20rate%20of%20rising%20prices,pay%20more%20for%20the%20product.