WTF is Inflation (Part 1)
Inflation Decoded. 101.
Let's start with the basics. What exactly does inflation mean? Well, inflation, be it in India or Pakistan, the definition remains constant. Inflation represents the rate at which the general price level of (a basket of) goods and services in an economy increases over a specified time period, typically on a quarterly basis, reflecting a decline in purchasing power.
Inflation, a cornerstone concept in economics, has historically been a catalyst for prolonged economic instability in numerous nations. Central banks often strive to establish their credibility as "inflation hawks," emphasizing their commitment to maintaining price stability. Meanwhile, political leaders frequently leverage anti-inflation rhetoric to secure electoral victories, only to face diminished political capital when their efforts to curb inflation fall short. Inflation is definitely THE common demon the common man is afraid of. What, then, is inflation, and why is it so important to any economy?
As already discussed, Inflation refers to the rate at which the general price level of both goods and services rise over a specified period, commonly measured quarterly. It is often assessed as a broad metric, capturing changes in the overall cost of living within an economy.
However, in modern times, inflation can also be calculated with a narrower focus, such as price increases in specific categories like food or services (e.g., school fees or edible oils). In essence, inflation quantifies the degree to which the purchasing power of a currency diminishes as goods and services become more expensive over time.
1. How Is Inflation Quantified?
The cost of living for consumers is influenced by the prices of various goods and services, weighted according to their proportion in household expenditures. To quantify the average cost of living, centralized government statistical agencies conduct household surveys to construct a representative consumption basket, comprising commonly purchased items, and monitor its cost over time. The cost of each basket, expressed as an index relative to a base year, is termed the Consumer Price Index (CPI).
The rate of change in the CPI over a specified period, referred to as consumer price inflation, serves as the primary metric for measuring inflation. For instance, if the CPI is 100 in the base year and rises to 108 in the current period, the inflation rate is calculated at 8% for that particular interval.
2. Enter: Price Volatility.Core consumer inflation isolates the fundamental and persistent inflationary trends by excluding administratively controlled prices and the more volatile components, such as food and energy, which are subject to seasonal fluctuations or transitory supply disruptions. Policymakers closely monitor core inflation as a more stable indicator of underlying price dynamics.
For a comprehensive measure of inflation at the national level, encompassing all sectors of the economy rather than just consumer expenditures, a broader index like the GDP deflator is utilized.
3. Relationship With GDP.
The CPI basket is largely maintained as a fixed reference over time to ensure consistency in measuring price changes, with periodic adjustments to account for evolving consumption patterns, such as the inclusion of new technological products or the withdrawal of obsolete goods. In contrast, the GDP deflator reflects the price changes of all goods and services produced within an economy, with its composition varying annually to remain aligned with current production structures.
While the GDP deflator provides a comprehensive measure of price dynamics, it includes non-consumer expenditures, such as military spending, and is thus less suited as an indicator of changes in the cost of living.
4.1. How Things Start Getting Muddy.
When nominal household income, always measured in current monetary terms, fail to increase at the same rate as prices, households experience a decline in purchasing power, as their ability to acquire goods and services diminishes. This decline reflects a reduction in real income, defined as nominal income adjusted for inflation. Real income serves as a key proxy for the standard of living; an upward trajectory in real income indicates an improving standard of living, while a decline suggests just the opposite.
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In practice, price adjustments occur at varying speeds. Prices of traded commodities, for example eggs, may fluctuate on a daily basis, while others, such as contractually fixed wages, adjust more slowly due to their "stickiness" in economic terms. In an inflationary environment, the uneven pace of price increases disproportionately impacts consumers, eroding the purchasing power of some more than others. This decline in real income constitutes the most significant cost associated with inflation.
4.2. Things Get More Muddy With Pensioners.
Inflation can create intertemporal distortions in purchasing power for parties engaged in fixed-interest-rate arrangements. For instance, pensioners receiving a fixed 5% annual increase in their pensions experience a decline in real purchasing power if inflation exceeds 5%. Conversely, borrowers with fixed-rate mortgages at 5% benefit from 5% inflation, as the real interest rate (nominal rate minus inflation) becomes zero, reducing the real cost of debt servicing. Higher inflation further eases the debt burden, provided the borrower’s income keeps pace with inflation.
However, this dynamic adversely affects lenders, whose real income declines. When nominal interest rates fail to adequately account for inflation, the redistribution of purchasing power creates winners and losers.
5. Project Zimbabwe.
Many nations have faced the challenges of high inflation, and in extreme cases, hyperinflation; defined as annual inflation rates exceeding 1,000%. A notable example is Zimbabwe, which experienced one of the most severe episodes of hyperinflation in 2008, with annual inflation estimated at 500 billion percent at its peak.
Such extreme inflationary conditions have proven economically catastrophic, necessitating stringent and often painful policy interventions to restore price stability. In some instances, this has involved abandoning the national currency altogether, as Zimbabwe did in favor of foreign currencies.
6. Reversed Inflation, A Jaundice.
While high inflation poses significant economic challenges, deflation, characterized by declining prices, this is equally undesirable. During periods of deflation, consumers tend to postpone purchases in anticipation of further price declines, reducing overall demand. This leads to diminished economic activity, lower income for producers, and subdued economic growth. Japan provides a notable example, having experienced prolonged economic stagnation largely attributed to persistent deflation.
To mitigate deflationary pressures during the global financial crisis of 2007–2008, the U.S. Federal Reserve and other central banks maintained low interest rates for an extended period and implemented additional monetary measures to ensure ample liquidity within financial systems.
7. What Do Economists Suggest?
The prevailing consensus among economists is that low, stable, and, most critically, predictable inflation benefits an economy. When inflation is both low and predictable, it can be effectively incorporated into price adjustment mechanisms and interest rate contracts, minimizing its distortionary effects.
Furthermore, the expectation of modest future price increases incentivizes consumers to advance purchases, thereby stimulating economic activity. As a result, many central banks have adopted inflation targeting as their primary policy objective, aiming to maintain price stability and foster economic growth.
Author is a Jack-of-All trades. He believes that specialization is for insects. Author is a public servant, a Linux evangelist, chess enthusiast and a long-term investor.
