11 August 2012

Day 64: Inflation - Part 1

What is this thing called inflation?

Inflation simply refers to the continuous increase of prices in an economy. So - two points are important to note: if prices go up and then remain stable for a while, we don't refer to it as inflation, as inflation only applies to a continuous increase in prices. Secondly - if the price of petrol keeps rising, but all other prices remain somewhat stable, we're also not dealing with inflation, because in the case of inflation all prices keep rising.

Measuring Inflation

One of the most common ways to measure inflation is by making use of the consumer price index (CPI). Remember from the previous blogs, that CPI reflects the cost of a representative basket of goods and services. To obtain the inflation rate, we calculate the percentage change int he CPI from one period to the next. Meaning - if the inflation rate is 7.5%, it means that the cost of purchasing a representative basket of goods and services increased by 7.5% from one year to the next.

Effects of Inflation

One of the major economic effects of inflation is that what a country is trying to sell to other countries, eg. exporting, will be more expensive for foreign countries to buy. Therefore, an economy loses its competitive edge on the international market and the performance of the economy generally goes down - in turn, affecting everyone operating within it. Another more obvious effect, of course, is that the cost of living increases, people become fearful and agitated and start throwing accusations around about who's to blame for the inflation. Some, however, claim that the greatest danger about inflation is that it will cause more inflation. When inflation occurs, people expect prices to keep on rising - therefore, they will quickly go and buy as much as they can now, before prices get even higher. Because more products are suddenly demanded, prices go up and thus, the inflation rate often increases, even pushing the economy in some cases towards 'hyperinflation'.

The Causes of Inflation

There are two main causes of inflation: demand-pull inflation and cost-push inflation.

Demand-pull inflation

The term speaks for itself - demand-pull inflation occurs when increased aggregate demand for goods and services pushes prices up. Aggregate demand can go up in any of the following cases, or combination of cases:
- when consumption spending increases
- when firms increase their investment spending
- when governments increase their spending
- when export earnings increase
In other words - whenever the amount of money in circulation increases in an economy, the prices will go up. Check: the more money is available in an economy, the less it is worth, which is reflected in higher prices - because with the same amount of money in your pocket, you can now purchase less stuff, which means that your money is not worth as much as it used to anymore.

Cost-push inflation

Cost-push inflation occurs whenever an increase in production costs is responsible for pushing up the price level. In other words:
- when wages and salaries increase
- when the cost of imported capital and imported goods increases
- when profit margins increase
- when productivity decreases
- when natural disasters occur, such as droughts or floods
In the case of cost-push inflation, we don't only have to deal with an increase in prices, but we also have to deal with a decrease in income and productivity. This is referred to as 'stagflation'.


  1. 1. Moderate inflation does not necessarily cause loss of competitiveness in international markets. Usually inflation occurs when there is an increase in money supply. Exchange rates adjust to changes in money supply faster then prices do. Prices are relatively sticky.

    2. Higher demand does not always come inflation. In fact, the level of demand which is significantly below production capacity pushes
    costs up, because it makes per unit fixed production costs and marketing costs to increase. Therefore a very low demand is just as likely to cause increase in prices as very high demand.

    3. Demand depends on the population structure. Young population demands a lot of goods and services. Older population is conservative with spending and has high propensity to save.

    4. Although it is true that hyprinflation is destabilizing for the economy, a moderate inflation is believed to help job creation and promote economic growth.

  2. Hi Nina,

    Cool that you're following this blog and adding your input. Though your statements are accurate (and btw don't contradict anything that was written), they are irrelevant to the purpose of this blog - which is to give readers a basic understanding of economic concepts so that they may gain insight into economics and how economics affects their lives. We're working here with simplified models so that the essence of the information can be grasped. The reality of economics is never this clear-cut and in practice contains many shades of grey - but the essence of the concepts remains and the understanding of them is really all that's necessary to gain a clearer understanding of what makes this world go 'round.

    Now, Nina - I challenge you to look further than your schooling and merely entertain yourself with the extent of your knowledge - but to really question the implications of this economic system. Instead of regurgitating the general opinions and beliefs about it as how you've been presented with them in your education, investigate it for yourself in common sense. Our economic system has become far more than some 'fascinating object of study' - it is the one thing that controls people's lives. So - wake up and smell the coffee. Time to take responsibility within the knowledge that you have.


  3. Ah, sure, I already woke up a few years ago, in 2007, to be precise, when I wrote a letter to CFA institute, saying that with economic theory such as we have and teach we are headed streight towards the next Great Depression. I have explained back then why. I did not get a reply from them. I am not sure if you are interested either. The truth is, our economuc theory IS a mess. The reality is, we need this screwed up system to manage the screwed up people we have. If all people were 100% mature, 100% conscientious, 100% hard working and 100% willing to share we could have a much better system. But people are the way they are. Most of them lazy, irresponsible and greedy. This is why despite all the theoretical considerations the current fkd up system is the only one that works despite all odds with a little help from the governments, religious, charitable and various regulatory organizations. Ah, yes, andone more problem. We have 9 billion people on Earth and counting. Some believe it is too much. So we need a system that can help us reduce the numbers, no matter how faulty it may seem.

    Not sure how this article is helping readers to understand the flaws of the current system. What I see is the concept tgat inflation is way too dangerous. And since it is sooo frkng dangerous let us make sure most people do not get access to money, because once theyget money they aregoing to demand goods and services, which will drive prices up. There are a couple of problems with this vision of inflation, which I have mentioned in my previous comment.

  4. Hi Nina,

    There is a different way, I suggest investigating www.equalmoney.org.

    In terms of the purpose of the blog - it's not to look at this one blog-post in isolation. In this post we're merely explaining the concept of inflation so that people may develop their vocabulary and more easily engage in/understand economic discussions and call out the bullshit.