Inflation Basics and Causes

Inflation Basics

• Inflation: A sustained increase in the general price levels of goods and services in an economy.
• Purchasing Power: Inflation decreases purchasing power, meaning consumers can buy fewer goods and services with the same amount of money.
• Hyperinflation: A rapid and uncontrollable increase in prices, often characterized by extremely high inflation rates.
• Consumer Price Index (CPI): A measure of the average change over time in the prices paid by urban consumers for a basket of consumer goods and services. It does not include interest rates on savings.
• Core Inflation Rate: The inflation rate excluding food and energy prices, providing a clearer picture of underlying inflation trends.

Causes of Inflation

• Wage-Price Spiral: A cyclical process where rising wages increase production costs, leading to higher prices, and then necessitate further wage increases to maintain living standards.
• Increased Consumer Demand: Excessive demand outpacing available supply can drive up prices.
• Increased Production Costs: Rise in raw materials, labor costs, or energy costs forces producers to raise prices to maintain profit margins.
• Decreased Money Supply: A decrease, or contraction in the money supply can cause a rise in prices.

Examples and Implications of Inflation

• Price Changes: A price increase from $0.75 to $1.25 for a soda can illustrate inflation influenced by cost and demand.
• Hyperinflation Examples: Post-World War I Germany experienced extreme hyperinflation.
• Savers and Inflation: When inflation outpaces interest rates, savers lose purchasing power because their savings do not grow in proportion to the rising prices.
• Fixed Incomes & Inflation: Retirees on fixed incomes are vulnerable to inflation as their income does not adapt to rising costs.
• Long-Term Loan Repayments: Inflation reduces the real value of loan repayments as the money in the repayment becomes less valuable.
• Economic Impact: Inflation on retirees, savers, and loan repayments highlight financial consequences on individuals.

Inflation and Employment

• Phillips Curve: A theoretical inverse relationship between unemployment and inflation; suggesting low unemployment correlates with higher inflation.
• Phillips Curve Limitations: The relationship is often less reliable due to global trade and wage rigidity.