Understanding Inflation: Causes, Measurement, and Types
Causes of Inflation
Demand-Pull Inflation
Demand-pull inflation occurs when there is an increase in aggregate demand (the total value of goods and services purchased in an economy over a period of time).
- Monetarists: Believe inflation is caused by an increase in aggregate demand due to an increase in the money supply. They base their explanation on the quantity theory of money:
M (Amount of money / money supply) * V (Velocity of circulation of money) = P (Average level of prices) * Q (Amount of production)
- Keynesians: Believe that price increases depend on the factors of production that enable the economy to meet increased demand.
Potential production of full employment: Is achieved when all goods and services are being used for the manufacture of goods and services.
The Keynesians say the increased demand on prices will depend on how close the current production level is to the potential level of full employment.
- Recession: The production level is below full employment potential; an increase in aggregate demand will be offset by an increase in production levels, and prices will be stable.
- At full employment: An increase in aggregate demand and inflation incurred cannot increase production.
- Approaching full employment: An increase in aggregate demand will increase prices.
Cost-Push Inflation
Cost-push inflation occurs when aggregate supply shocks cause a rise in prices driven by increased production costs. This can be caused by:
- Increased labor costs
- Increased prices of widely used raw materials
- Increased financial burdens
Inflation and Its Measurement
Changes in the price level cause changes in the purchasing power or value of money. An increase in prices reduces purchasing power, and a decrease in prices increases it.
Inflation: Continued growth in the general price of goods and services in an economy.
Inflation is measured by the inflation rate, which is calculated using price indices. The most used is the Consumer Price Index (CPI), developed by the National Institute of Statistics from the prices of items normally purchased by families and that make up the basket of the CPI.
We can differentiate between:
- Monthly inflation rate (rising prices for 1 month)
- Accumulated rate of inflation (rising prices since the beginning of the year to the current month)
- Annual inflation rate (rising prices for the last 12 months)
The EU uses the Harmonised Index of Consumer Prices (HICP).
Inflation Rate Types
- Moderate Inflation: Prices rise slowly; inflation rates do not exceed 1 digit. Prices are stable, and citizens rely on the value of their money.
- Galloping Inflation: Annual inflation rates are 2 or 3 digits. Money loses value quickly, so the public will hold the absolute minimum.
- Hyperinflation: Inflation rates reach such heights that you lose control over prices, and money has little value. Unbridled inflation will lead to the collapse of the monetary system and a return to barter.
Runaway inflation and hyperinflation have occurred in Latin American countries in recent years: Argentina, Peru, and Brazil.