Inflation: Causes, Measurement, and Economic Impact
Understanding Inflation: Causes and Measurement
8.1 What is Inflation?
Inflation is the continued and widespread increase in the prices of goods and services in an economy over a period of time. A core problem that any economy must solve is inflation. If prices rise, fewer goods can be purchased with the same amount of money. When economies become increasingly interdependent, rising prices in one economy (and not in others) means that it sells fewer goods and services to others and buys more products from them. An economy will reach the goal of price stability when the price growth is no higher than 1.5%. When price growth exceeds this, we say there is price instability.
8.2 Measuring Changes in the Value of Money
From one year to the next, some services cost us more Euros, although some can also lower their prices. It is important to know how prices evolve in the economy, so we can know how the value of money is changing.
- Consumer Price Index (CPI)
How it’s made:
- It is based on what the buyers of the country purchase. Purchases change over time, changing the composition of what is bought.
- Each of the goods and services that make up the shopping cart is weighted by the volume of spending.
- It shows how prices have evolved and the variation in the period is calculated.
It is produced monthly. We say there is inflation or deflation when its evolution over a year shows that prices have increased or decreased compared to the previous year.
Deflation: Continued and widespread decline in the prices of goods and services in an economy over a period.
- Harmonized Index of Consumer Prices (HICP)
This statistical indicator provides a common measure of price trends and inflation, allowing comparisons between EU countries. The main difference with the CPI is the population coverage.
8.3 Causes of Inflation
Keynesian Theory: When economic agents in an economy raise costs and production exceeds capacity, there is an increased demand that is not accompanied by increased supply. Only the increase in prices achieves equilibrium, resulting in demand-pull inflation.
Monetary Theory: An increase in the amount of money that families, businesses, and the state have is experienced in excess of the production of goods and services.
- Keynes accepts that inflation stems from an excess of demand, but the effect on prices depends on the situation of the economy:
- If all resources are being used and aggregate demand increases, prices will rise.
- When there are unused resources or factors of production, increased demand will create an increased production or supply and therefore will not influence prices.
Monetary theory explains that if the amount of money increases without a corresponding increase in production, consumers are willing to pay more for goods and services. They compete with each other, and producers will increase prices, seeing the interest and purchasing capacity of consumers. In an economy where inflation is higher than that of the economies it sells to or buys from, production decreases, and fewer goods and services are sold overseas while more are bought, which also affects “what to produce”.
The difference between Keynesian and monetary theory is that the increase in aggregate demand may be caused by both monetary and non-monetary factors.