A guide to what inflation is, how it works and why it is important

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What is Inflation?

Inflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money).

The causes for inflation in the short term and medium term remain a contested issue among economists all over the world. However, there is a consensus that, in the long term, inflation is caused by changes in the money supply.


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How is Inflation Calculated?

Inflation is most commonly calculated by observing changes in price indices. Generally, changes in the Consumer Price Index (CPI) are used as a proxy for inflation. Let’s say that the CPI for a given nation was 210 at the end of 2017 (the base year) and 220 at the end of 2018. Calculating the percent change in those values will provide us with the inflation over this time period:

Inflation Example

Thus, we can conclude that inflation was approximately 5% in 2018.

If inputs to produce high-demand, inelastic goods (such as oil or medication) increase in price, suppliers will be compelled to raise their prices to compensate. This can be due to a number of reasons, such as environmental catastrophes, tariffs, government sanctions, or scarcity. If widespread enough, the phenomenon can nudge the CPI higher, resulting in inflation.

The opposite is also true – whereby lower input costs can result in deflation.

How Does Consumer Demand Affect Inflation?

Holding other factors the same, a rise in consumer demand for goods will lead to an increase in the price of goods (CPI), as shown below:

Demand Inflation

Consumer demand for goods may increase due to various factors, such as changes in consumer appetite, long-term scarcity prospects, or an increase in the money supply. The opposite is also true; a decrease in consumer demand will result in a lower CPI, and thus deflation.

How Does Money Supply Affect Inflation?

In the long run, money supply affects the purchasing power of a currency as per supply and demand rules. The diagram below illustrates how an increase in the money supply in an economy would affect inflation:

Inflation: supply and demand

The money supply can increase in a variety of ways, namely if governments print more money or make credit more easily accessible. Lower interest rates may spur consumer borrowing and lead to an increase in the money supply. In the diagram above, we can see that an influx of money in an environment where demand remains the same will result in a devaluation of the currency in question.

The opposite is also true; if governments restrict the money supply and all else remains constant, the currency will begin to appreciate in value.

Effects of Inflation

1. Decrease in unemployment

When the price of goods increase, so will revenues and, subsequently, profits for private enterprises. The influx of capital will enable businesses to expand their operations by hiring more employees.

2. Decrease in the real value of debt

As explained above, inflation is associated with a decrease in interest rates. Low interest rates will cause the value of debt and related debt instruments to decrease. This may incentivize consumer spending as consumers may be more inclined to take on more debt during the period. On the other hand, businesses may struggle to sell bonds to finance their operations, as bonds would become less attractive investments.

Additional Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA®)  certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

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