# What is inflation?

### Pablo Aznar

#### 09/02/2022

Nowadays, inflation is an issue of concern to many people. This is due to it reaching its maximum values. However, what does this mean? And, what are the consequences?

In this post, we will to try to answer these questions, and explain what inflation is, what consequences it has, why it is caused and how it is calculated.

Inflation measures the increase in prices of goods and services in the market over a given period of time. This leads to a decrease in the purchasing power of currencies, meaning that the value of money decreases.

### But, what are the consequences of inflation?

High levels of inflation can be harmful. However, low levels can also have a major impact. Therefore, inflation may have negative consequences.

High inflation creates a lot of uncertainty, and this leads to several problems. The investment will be reduced, which will also result in lower economic growth and may create instability. In addition, due to the currency purchasing power reduction, exports will be reduced and international competitiveness will be affected. Moreover, if inflation is higher than interest rates, savings will lose value.

Nevertheless, it can also have positive consequences.

On one hand, moderate levels of inflation cause goods and services’ prices to rise. This leads to higher investment and the economy grows. In addition, as money loses value, it encourages people to spend more.

On the other hand, negative inflation (known as deflation) can be considered as a threat to the economy and can result in a lower growth. People spend money less as prices are expected to be lower in the future. This can potentially lead to a recession.

Therefore, it is beneficial to keep inflation at a certain level. Generally, the governments and central banks of each country set a target near 2% of inflation.

## Types / Causes

• Demand-Pull inflation arises when there is an increase in demand which places it at a higher level than the available offer of goods and services. As it is widely said, “too many dollars chasing too few goods”. So, in consequence, the prices rise. The main reason for this to happen is that the economy grows and people feel more confident and spend more.
• Cost-Push inflation is originated when the cost of production materials, goods, and services, rises. This will therefore lead to a higher cost of production, which will mean an increase in the price of the final product.
• Built-In inflation is originated by the expectation of future inflation. Therefore, workers will demand higher salaries which leads to higher costs of production, and in consequence, higher prices. These expectations are usually created by demand-pull or cost-push inflation. This is due to the fact that, if nowadays prices are rising, people will expect them to continue rising in the future.

## How is it measured?

Several indexes are used in order to represent inflation. The following are among the most representatives: Consumer Price Index (CPI), Producer Price Index (PPI), Gross Domestic Product (GDP) Deflator.

### Consumer Price Index (CPI)

The Consumer Price Index is the most used and famous indicator for inflation.

This index compares the evolution of the price of a set of goods and services over time. In order to do so, a basket of goods and services is used. Thus, a classification of products is made in order to make a selection of representative articles in which people spend most of their money. Then, different weights are assigned to every component of the basket and in that way, the price of the basket is calculated. Afterwards, the price of that basket is compared to the price of another year and that variation is the inflation.

$Inflation = \frac{CPI_{Current Price} – CPI_{Former Price}}{CPI_{Former Price}}$

Every country of the European Union has its own national statistical institute which is in charge of calculating the index. Then, every institute sends the index to the Statistical Office of the European Communities, Eurostat. Using all these indexes, Eurostat calculates the index of the euro area. Furthermore, Eurostat also monitors that every EU country satisfies certain standards.

So, for example, Spain and the USA do not use the same basket of goods. Does this mean that the indexes are not comparable? To find it out, let’s see the weights that are assigned to each group of the goods that make up the baskets for each of the two countries.

As it is shown, the weights are not the same, but they are very similar, as well as the methodology used.

### And, how many articles make up the basket of goods?

The Spanish basket of goods is composed of 955 articles for which there are different methods to obtain its prices. One of them is web scraping, which is a technique that consists on collecting automatically the data from web pages. Another method is Scanner Data, which consists on obtaining the data directly from the databases of the companies with the register of the sales made that particular year.

### Gross Domestic Product (GDP) Deflator

This metric shows the variation in the price of all goods and services produced by a country, including exports but excluding imports.

Specifically, it shows how much of the change in GDP is due to that change in prices. GDP is subject to changes and therefore does not reflect inflation on its own. For this reason, a specific year is taken as a reference year and then the current prices are compared to those of the year taken as a reference.

This makes the movements shown in the GDP deflator similar to those of the CPI.

### Producer Price Index (PPI)

The PPI was previously known as Wholesale Price Index or WPI. It measures inflation by taking into account the changes in production costs using a basket of goods. It is a monthly measure of the evolution of products’ prices that producers need for their output.

## Is there a way to predict future inflation?

Predicting the value of inflation can be very useful, but at the same time it can be a hard task. One way to do this could be by using Treasury Inflation-Protected Securities (TIPS).

TIPS are US bond that protect investors against inflation. Therefore, they reflect expected movements in the CPI. Therefore, using the following equation, we can obtain the expected inflation.

$Expected\;Inflation = Treasury\;Yield – TIPS\;Yield$

## How can inflation be controlled?

As inflation is desirable to be kept within an acceptable range, countries’ central banks and governments set an target. This target is common to be 2%. But, how do they control the value of inflation in order to meet this target?

The main way to reduce inflation when it reaches very high levels is to reduce money supply. This can be achieved by:

• Increasing interest rates. By doing so, people will be taking out fewer loans and thus spend less, which will lead to lower prices.
• Increasing banks’ reserve requirements. If banks need to hold more money in reserve, they will have less to lend to their customers.

Besides, it has to be taken into account that very low levels of inflation are also detrimental. Therefore, in order to increase it, governments would need to apply measures contrary to those discussed above.

## Conclusions

In this post, we have seen what inflation is, what are its consequences, why it is caused, how it is measured, and which are the different indexes that are used to measure it.

High levels of inflation can be detrimental as well as low levels. For this reason, it is desirable that the value is kept within a certain range, and that is why governments and central banks usually set a target value of 2%.

## References

[1] https://www.investopedia.com/terms/i/inflation.asp