Inflation

What is inflation?

Inflation is the sustained variation in the price of goods and services in a country in a specific period. The increase in prices causes the value of the currency to decrease, and it is no longer possible to buy the same amount of goods as in a previous period.

Depending on the way it is presented, we can identify various types of inflation grouped into two large categories that consider different criteria:

  • According to the behavior of the price increase.
  • According to the percentage of price increase.

The word inflation comes from the Latin "inflatio”, Which means to inflate.

Types of inflation

Inflation has several classifications according to the increase in the prices of goods or according to the percentage of that increase.

According to the behavior of the price increase

The fall in the Gross Domestic Product (GDP) or the intervention of the State are some factors that can generate price increases.

GDP is the income that a country receives from the sale of the goods it produces. If those revenues fall, the State reduces its options for internal financing and is forced to intervene, printing more money to solve its deficit.

This can lead to three types of inflation: stagflation, reflation, or core inflation.

Stagflation

This is a price increase that is also accompanied by a decrease in the Gross Domestic Product (GDP) for 6 consecutive months.

The term stagflation is a combination of stagflation (stagnation) and inflation (inflation). It was coined by the British finance minister Ian Mcleod to refer to the economic situation of the United Kingdom in 1965, which was experiencing a severe post-war recession.

Example of stagflation with 755% inflation and a -12% drop in GDP

Reflation

It is a type of inflation generated by the State to stimulate the economy and not fall into deflation (negative inflation or prolonged decrease in prices).

These stimuli are generally applied in the form of fiscal policies that inject liquidity into the financial market, such as lowering interest rates to stimulate consumption.

Underlying inflation

It is the variation in prices that is obtained based on the consumer price index, which allows an approximation to the behavior of inflation in the medium term. Therefore it is a tool to implement monetary measures more quickly.

Underlying inflation in the second quarter of 2020 in Mexico, according to data provided by the National Institute of Statistics and Geography, INEGI.

According to the percentage of the price increase

The severity of an inflationary crisis can be measured by its percentage. Based on that, it can be:

Creeping inflation

It is when inflation fluctuates in percentages that do not exceed 10%. Developed or developing countries have crawling inflation, such as Norway, which in 2019 had a price variation of 2.9%.

Another example is that of inflation in Mexico in 2019, which was 2.8%, the second lowest inflation rate in that country since 2015.

Moderate inflation

These are price variations that exceed 10%, but are still considered manageable.

An example of moderate inflation is that of Haiti, it had a price variation of 17.3% in 2019.

High or galloping inflation

It is a type of inflation with a very high rate, which can be controlled with the application of economic policies. It can turn into hyperinflation if these measures are not implemented in time.

Argentina is an example of rampant inflation. In 2019, the price variation was 53%, and as part of the government decisions to stop this increase, the prices of essential products were regulated and an exchange control regime was established.

Hyperinflation

In this case, the price variation is not only extremely high, but also dizzying. The prices of goods and services rise every day (and can even change during the same day, in very serious cases). The currency has lost all value, with which the purchasing power of the population is almost nil.

One of the strongest examples of hyperinflation in contemporary history is that of Venezuela, with an inflation of 7000% in 2019.

5 causes of inflation

Inflation is a phenomenon that can be caused by multiple factors, as described below:

1. Imbalance between supply and demand

When a product or service is highly sought after by consumers (demand) but there is not so much available (supply), an imbalance is generated in the economy.

Because the supply is small, consumers are willing to pay high prices to get the products they need, and this abrupt variation can lead to inflation.

Essential product shortage scenarios are an example of an imbalance between supply (there are too few) and demand (there are many buyers). This, in addition, generates additional distortions, such as the appearance of a parallel market or black market and speculation.

2. Increase in production costs

If production costs rise, companies increase the price of the final product to maintain production.

If this situation is generalized in a specific item, it is possible that it is a trigger for inflation. A concrete example is a crisis in the steel sector, which can affect the entire automotive industry in a country and cause an inflationary crisis.

3. Price adjustments

When companies increase prices progressively to avoid sudden increases, then the demand for the product falls as a consequence of the decrease in the purchasing power of consumers.

Although the initial objective of this type of strategy is to avoid an impact on the economy, the end result can be an inflationary crisis.

If there is a lot of supply but little demand and this distortion is not corrected in time, it can generate negative inflation or deflation.

4. Increase in the amount of money in circulation

When the state needs to finance its fiscal deficit, one of the most common ways to do this is by printing more money. If the money supply increases, but the demand for money remains the same or decreases, an imbalance is generated.

This can stimulate a devaluation of the currency, with which money loses value, people decrease their purchasing power and causes an inflationary crisis.

5. Absence of preventive economic policies

If a country already has price increases or a lot of money in circulation with respect to demand, the right thing to do is to design monetary policies that help stabilize these factors.

When this does not happen, or when measures are applied but prove to be ineffective, inflation is inevitable.

4 consequences of inflation

Inflation is a phenomenon that is necessary and that can even be stimulated to generate a balance in national economies. However, when it gets out of control it has devastating consequences, especially for consumers, who see their quality of life diminished.

These are some of the negative effects that inflation generates:

1. Currency devaluation

Inflationary crises are generally associated with devaluation processes. The measures that the States take to correct the variation in prices, such as exchange control or the injection of money into the economy, generate a decrease in the value of the currency.

On a day-to-day basis, this means that if in the previous month 1000 pesos were used to buy 10 loaves, today with those 1000 pesos you can now only buy 9 or less. Money loses value and, with it, people's purchasing power diminishes.

2. Economic uncertainty

Inflationary processes are not usually resolved immediately, this prevents the productive sector from making decisions in the medium or long term without knowing how they can affect it.

Uncertainty can lead to further price increases or speculation, as a way to protect future production costs, but this only adds to the problem.

An example of how economic uncertainty is reflected is the closure of foreign companies when it is not feasible for them to continue operating under conditions of uncontrolled inflation.

3. Tax gap

In periods of inflation, governments increase wages and salaries to counteract the decline in purchasing power, and this may imply more taxes for citizens.

However, although the income is higher in quantitative terms, the value of that money has decreased. This implies a benefit for the States that can raise a greater amount of money, but the citizens see their income even more depleted.

4. Benefits on debts and credits

The loss of the value of money generated by inflation only has positive consequences for those who have debts or credits (payments with cards, mortgages, etc.). If interest rates do not go up (which generally happens in these types of situations), the amount owed is the same, but with less value.

Banks and financial institutions receive the payments, but the value of that money is much less than it was when people and companies contracted debts with them.

How inflation is measured

Inflation is measured with a formula that considers the variation of an index over a period of time.

The result obtained is what we know as the inflation rate, that is, the variation in prices for a specific period, expressed in percentages.

Inflation rate: how to obtain it

The general formula to calculate the inflation rate is:

Inflation rate = (current IP - historical IP) / current IP * 100

  • IP is the price index that will be used to measure the variation.
  • Current IP is the price at the time of calculation
  • Historical IP is the moment in which the period to be measured began.

Three different indices are used to calculate inflation:

  • CPI or consumer price index.
  • WPI or wholesale price index.
  • DIPIB or implicit GDP deflator.

The CPI is the most widely used in the world because it uses variations based on the price of essential products, so its values ​​are closer to reality. The other two formulas, while correct, are not applied as often.

What is the CPI and how is inflation calculated with this index?

It is the index that measures the variation in prices of basic goods and services that are consumed by a family in a specific period. An example of this is the family basket. Its formula would be:

CPI inflation rate = (current CPI - historical CPI) / current CPI * 100

The CPI does not include energy products or perishable foods because their prices are volatile, which would alter the calculation.

As the CPI is usually calculated monthly and excludes categories with volatile price variations, it is the most widely used indicator in the world.

Example of calculating inflation with the CPI

To calculate the inflation of a country during 2019, we need its current and historical consumer price index to apply the corresponding formula. In this case, the indices are:

  • CPI 2019 (current): 90.5
  • CPI 2018 (historical): 78.3

Therefore, the calculation would be:

CPI inflation rate = (90.5% - 78.3%) / 90.5% * 100

CPI inflation rate = 12.2% / 90.5 * 100

CPI inflation rate = 0.13% * 100

CPI inflation rate = 13%

What is the MPI and how is it calculated?

The wholesale price index or WPI is one that measures the variation in prices of wholesale goods and services. For example, the sale of food or raw materials in bulk, which are usually traded in large quantities.

The MPI is used to measure the productivity and competitiveness of countries in trade matters. The formula to calculate inflation using this index is:

Inflation rate MPI = (current MPI - historical MPI) / current MPI * 100

Example of calculating inflation with the IPM

We can calculate wholesale inflation with the current and historical wholesale price index of a country. In this case:

  • MPI December 2019 (current) 4.1%
  • MPI January 2019 (historical) 0.8%

With these data, the calculation would be as follows:

Inflation rate IPM = (4.1% - 0.8%) / 4.1% * 100

IPM inflation rate = 3.3% / 4.1% * 100

IPM inflation rate = 0.8% * 100

Inflation rate IPM = 80%

What is the DIPIB and how is it calculated?

It is the difference between nominal gross domestic product and real gross domestic product.

Nominal GDP expresses the value of the market price of the products generated by a country, with the increases and decreases that have occurred during a period.

Real GDP ignores all the variables that can influence price changes during a specific period. The result is a reference price that is used to make comparisons with other periods.

The formula to obtain the DIPIB would be the following:

DIPIB inflation rate = nominal GDP / real GDP * 100

Example of inflation calculation with the DIPIB

To calculate inflation using the DIPIB, nominal and real GDP are needed. In this case, the data provided are:

  • Nominal GDP 2010: 10283 108 759.7 MM
  • Real GDP 2010: 8,230,981.2 MM

With these inputs we can apply the formula:

DIPIB inflation rate = 10283108759.7 / 8230981.2 * 100

DIPIB inflation rate = 1,249.31 * 100

DIPIB inflation rate = 124,931

In addition, after calculating the inflation rate, it is possible to make an inflation adjustment, which is an update of the budget based on the CPI to control expenses during a period. This adjustment is made by the State and the private sector to protect their assets.

You may be interested in reading Gross Domestic Product

Difference between inflation and deflation

Deflation is a sustained decrease in prices for a period of six months, as a consequence of an excess of supply and a decrease in demand. Although it is usually categorized as a type of inflation, it is actually the opposite phenomenon of inflation.

Deflation seems like an ideal situation for consumers because goods are cheaper, but it is as serious an economic phenomenon as price increases.

If the demand for products decreases, companies lower their prices to be more competitive. But if the situation continues, they will have to lower costs to maintain a minimum profit. This can generate massive cuts in jobs and with it, a decrease in consumption, which generates a negative cycle in the economy.

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