How Does Inflation Work? [Inflation Definition and Examples]

Wondering how inflation works or perhaps looking for the inflation definition?

This article will explain how inflation works, the definitions and different theories surrounding inflation.

The price of items does not just increase out of the blues. There are some underlying forces that contribute to the reduction in the buying power of any currency, the dollar included.

The simplest explanation of inflation is the principle of demand and supply.

In a given open and free market, when the demand for a given product is higher than its supply, its prices will increases.

And if its supply is higher than its demand, then its price automatically goes down. In other words, when there’s so much of a product in the market, its value goes down.

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Demand-Pull Theory

This principle equally applies to money. Whenever there’s too much of it in circulation, then the value of a dollar goes down. Classically, this theory is explained as a lot of money chasing few goods and is referred to as the demand-pull theory.

At this point, you could be wondering: how possible is it to have too much money in circulation? This cannot be explained without mentioning the Federal Reserve. This is the gatekeeper of the money supply in the US. Its policies influence the amounts held in banks and the interests incurred by those that take loans.

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Cost-Push Theory

This theory tries to explain that an increase in labor and raw materials costs tends to drive the prices of goods and services. Taking bread for example, when the wheat prices go up, flour prices increase which in the end increases the price of bread.

Does the increase in the price of given products directly cause inflation?

Well, economists tend to disagree because if the demand for bread goes up, bakers will not increase their prices right away.

Instead, they deplete their stock first then buy more from their supplier who in turn buys it from farmers. If the increased demand is experienced by all bakers, some of the suppliers will offer to buy the wheat at a higher price, which in turn affects the price of flour and finally bread.

In this case, it may seem that the price of raw materials caused the increase in the price of bread, but in the real sense, the increase in price was driven by the increase in demand.

The change in individual prices does not necessarily mean there has been inflation.

For an increase in prices to be termed as inflation, there has to be a persistent rise in prices. For this reason, even the OPEC embargo experience where prices of gasoline spiked wasn’t the main cause of inflation.

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How Can Inflation be Measured?

Consumer Price Index (CPI)

It is interesting to note that for inflation to be established, one has to go out and collect the data of all goods and services in the economy.

CPI is measured with respect to the current CPI market basket.

If for example a shopping basket has more than 200 categories of items in the eight major groups: housing, food, transport, recreation, medical care, apparel, communication, and education, then that would be the CPI market basket.

Every two years, over 7000 American families are interviewed on the specific items that can go into the CPI market basket.

After every month, teams of economists are sent out to record the actual prices of over 80,000 items.

Once the price changes have been established, the overall increase is reported as the CPI. It is important to note that this is not a dollar figure.

It is based on price levels that can be dated back to 1980. Baseline figures are equated to 100 as the CPI.

When a given CPI shoots to 200, it means that there has been a 100% increase in prices as compared to the early 1980s. This then necessitates the need to reset the BSL base year.

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What are the Dangers of Inflation and how can they be Controlled?

Inflation hurts the economy in the following ways:

Lose of investment value: If your investment in a CD projected yield of 4% but inflation rose to 3%, then your return is only 1% in real dollars

Increased interest rates: Should there be projected inflation by the bank, they will charge a higher interest rate so as to cover up on their losses.

Erosion of fixed incomes: Payments such as pension or retirement benefits do not increase with inflation.

Hard times ahead: Inflation makes it difficult for businesses to plan ahead because inflation makes it difficult to project the future price of items based on the cost of labor and materials. In turn, this may discourage investors and economic growth.

To curb inflation, Fed takes control of money supplies in the following ways:

  • Buying and selling of bonds to banks and paying for securities in cash. Buying increases the amount of money in circulation while selling leads to a decrease.
  • Lowering reserve requirements by banks so that there’s more money in circulation because the percentage of deposits that a bank cannot lend out is reduced.
  • Lowering the discount rates on short term loans. If a bank is lent money at a lower interest rate, they, in turn, lower the interest they charge on their loans.

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