Inflation is a generalized increase in the prices of goods and services of an economy over a period of time.

When we hear that there has been inflation means that prices have gone up or have been “inflated”, hence the name.

There is inflation when the prices of the set of goods and services of an economy increase steadily. That is when the average price of all goods and services in a country rises.

The rise in prices causes the loss of purchasing power of citizens. Or put another way, if there is inflation means that with the same money we can buy fewer things than before. For example, if the price of oranges is € 2 per kilo, a person with € 10 can buy 5 kilos, but if the price rises to € 2.5 and you can only buy 4 kilos.

Why is inflation such an important concept?

It is a phenomenon that occurs in almost all countries, in fact, central banks always try to get some inflation in their country, usually between two and three per cent. Because if there were no inflation, prices would fall ( deflation ), which is the fear of any economic responsibility of a country. Deflation can slow consumption and economic growth. It can also lead to a deflationary spiral with terrible consequences for the country’s economy.

Inflation is one of the most important aspects of the study of macroeconomics and monetary policy of central banks. For example, the main objective of the European Central Bank (ECB) is to achieve price stability, maintaining an annual inflation rate of 2%.

One of the functions of the prices is to allow the buyers to indicate the quantity of product they wish to buy according to the price of the market and the entrepreneurs to determine the quantity of product they wish to sell at each price. Prices ensure that resources are allocated efficiently to achieve market equilibrium and, thus, resources can be allocated efficiently. However, the most common is that prices increase, causing what is called inflation.

Advantages of inflation

Many times it is said that inflation is good, but it is not that it is good in itself, but even if the prices of an economy rise, wages also tend to rise in line with this price increase. Thus, in the end, the purchasing power of citizens remains stable. It can be good, as long as it is stable and not very high, for the following reasons:

  • The rise in prices helps reduce the value of debts, both of households, companies and the Government. This is because if there is inflation in an economy and our wages rise at the same rate, but the debt remains the same as before, the real value of the debt will be lower than before the prices rose.
  • The rise in prices also causes people to prefer to consume now instead of later because then prices will be more expensive. This is essential for money to circulate and for the transmission of goods in an economy. It is the gear of capitalism.

Disadvantages of inflation

Its main drawbacks are:

  • Loss of purchasing power: If the rise in wages is not at least equal to the increase in prices, the purchasing power will decrease. We could be happy if we raise the salary 10% in a year, but if inflation has been 20%, we can actually buy 10% less with that salary.
  • Reduces savings: Inflation causes money to lose value, so it will motivate people to consume and spend money, instead of saving it, because if money is going to be worthless in the future, citizens and investors will prefer to spend it now.

How is inflation calculated?

Given the difficulty of calculating the variation of all prices in an economy, there are two main indicators to know how much prices are rising:

  • An approximate indicator is the consumer price index (CPI), which is composed of groups of goods and services, from food, clothing, medicines to communications, transportation, housing and leisure.
  • Another way to calculate inflation is through the GDP deflator, which takes into account the price variation of all goods and services produced in a country.

Causes of inflation

Inflation can occur for four reasons: for an increase in demand, when the costs of raw materials increase, for their own expectations or for increases in the money supply. See in detail the causes of inflation.

Types of inflation

When talking about rising prices, certain terminology is usually used to describe the different forms of price increases. Among the types of inflation are:

  • Stagflation: It occurs when there is inflation and also a decrease in GDP.
  • Underlying inflation: It is that price increase that excludes energy products.
  • Deflation: This is negative inflation. That is, when prices instead of rising, they go down.

In addition, according to the percentage of increase, we could say that the following levels exist:

  • Moderate inflation: When the price increase does not reach 10% per year.
  • Galloping inflation: It occurs in the case of excessive inflations. We are even talking about two and three digits.
  • Hyperinflation: These are price increases that exceed 1000% in a year. They cause serious economic crises.

To know more about the types of inflation, it is recommended to read:

Types of inflation

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