What is Inflation?

//What is Inflation?
What is Inflation? 2017-10-05T02:54:19+00:00

Definition: Inflation is the devaluation of a currency marked by a sustained trend of rising prices in the economy. In other words, the value of each dollar is less, which causes the general price of goods to increase. This is typically caused by an increase in the money supply relative to economic activity.

What Does Inflation Mean?

What is the definition of inflation? Inflation depresses the purchasing power of money, reinforces the unequal distribution of income, condenses the competitiveness of the economy, and encourages imports. Economists use the Consumer Price Index (CPI) to measure it by measuring the price changes in a determined market basket of core goods and services. This basket typically includes gasoline, food, clothing and automobiles.

Demand-pull inflation occurs during periods of strong economic activity. The full employment of available production and technology resources causes the price of goods and services to rise, yet the supply cannot automatically adjust to the increased demand. Therefore, the prices rise to the level that the total demand equals the total supply.

Cost-push inflation occurs during periods of slow activity. The price of goods and services exceeds their marginal cost due to oligopolistic profits, trade unions, low productivity or government taxes, or exceeds the price of raw materials. In both cases, cost-push inflation depresses the value of money, leading to a rise in interest rates and a reduction of investments.

Other types include are imported and structural inflation, hyperinflation, stagflation, and deflation.

Let’s look at an example.

Example

Brian invests $1,000 in a fixed-term bond. At the end of year one, the bond yields 6% and Brian gets $1,060. However, when Brian first invested in the bond, the inflation rate (IR) was 3%, so he would gain 3% on investment. Today, at the end of year one, IR is 4.8%, so Brian is actually gaining 1.2% on investment. This is how inflation influences the value of money.

Donna borrows $1,000 at 15% rate for one year. If at the end of year one, the level of prices has increased 25%, the real (inflation-adjusted) value of $1,000 is $1,000 / 1.25 = $800. If we take into account the interest 10%, then the real (inflation-adjusted) value of money at the end of year one is $1,100 / 1.25 = $880. So, in essence, what happens is a transfer of purchasing power from the lender to the borrower equal to $1,100 – $880 = $220.

A more simplistic example is to simply look at the cost of living year over year. Cost of living tends to increase at the IR because the currency is being devalued and as a result the goods and services are increasing in price.

Summary Definition

Define Inflation: Inflation is the economic phenomena where a currency is devalued because of an increase in the money supply relative to output creating a rapid rise in prices of goods and services.