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What Is Inflation? How Does Inflation affect the economy?

Inflation history

1000 years ago, in Mesopotamia, tribes were the first to utilize a bartering system to get the food, weapons, and spices they needed. These ancient people realize they could use their time to create value for others. In return, they exchange this value for other goods and services. This idea is merged into the advancement of the human species. Today, that same process is still intact. It’s called the economy. 

Inflation definition

Inflation is a continual rise in the price of goods and services. If the number of currency units in a system rises far more than the supply of goods and services in the economy, prices will increase. So, what can cause inflation? How do we measure inflation? And what does inflation affect? Let’s begin by examining three types of inflation. 

Relation between economy and Inflation

Each person has a clock and a unique way they provide value to others, people can store value, currencies, or assets that can hold the value of one’s past long into the future. 

Storing value allows people to think long-term, perhaps someone wants to save up for a house, take a vacation, or start a company. Inflation is a hidden tax on time. When a person uses a specific currency that a government devalues their past time D values, Dreamhouse vacation spots or new product inventory rose in price compared to the currency they store their wealth in. Understanding inflation is vital for every individual who wants to protect their time. 

Types of inflation:

  • Monetary inflation refers to a rise in the broad money supply. In other words, it’s not about prices rising, it’s about the amount of money in the financial system increasing. Broad money supply consists of all bank deposits for both individuals and businesses than physical currency in circulation. Two main forces drive the broad money supply, banks process private loans and create new deposits, or the government issues bonds, which is essentially debt, the central bank prints money to buy large portions of this government debt.  
Monetary inflation.
  • Consumer price inflation: occurs when the price of goods and services climb. The Consumer Price Index also known as CPI measures these prices, disagreement arises when deciding on what goods and services should be in CPI measurements. If household a has different spending habits than a wealthier household, products and services should be calculated into a formula that reflects the majority. 
  • Asset inflation often happens during periods of high wealth concentration and low-interest rates. If the central bank were to create a trillion new dollars and give the 100 wealthiest people in the country an extra $10 billion each, what would they spend it on? The rich have already fulfilled their physical needs and desires, so they’ll buy more financial assets. If the government and central bank were to distribute $5,000 to every low-income American, a significant portion of them would purchase more everyday goods.

 How does the supply of money impacts CPI?

Over the long run, technology should continually improve and push prices lower. However, Money Creation processes and other policy choices can create inflationary results that offset technological price reductions. Broad money growth is one of the most closely correlated variables to consumer price inflation. 

CPI chart

For the first exception period, the United States experienced a technological revolution. The age of steel, electricity, and heavy engineering allowed for tremendous growth. While mass emigration brought cheap labor to emerging markets. London the West became a mecca of opportunity. Stories of riches made off oil and gold spread like wildfire. The transcontinental railroad connected east to west. Soon after the lightbulb was commercialized leading to the mass adoption of electricity. The banking system grew as a share of GDP from tiny to zero Significant connecting more financial capital to innovative people and industries. During this time, the dollar was backed by gold as well. From the 1990s to present times, the United States came across another technological revolution through the age of information and telecommunications. The exponential increase in computer power and networking allowed the digitization of many processes. Corporations outsource domestic labor to cheaper places like Mexico and China, which place downward pressure on domestic wages and prices. Automation displaced a portion of work and drove wages and prices down further. 

In the previous example, the United States experienced a rise of a superpower backed by innovation, new land, and resources. In contrast, the United Kingdom experienced the gradual decline of a superpower and the loss of the global reserve currency, their broad money supply per capita and price inflation remained correlated. As a final example, Australia experienced a strong correlation until the rise of China as a trading partner. increased trade gave Australia an economic boost allowing their money supply to grow faster than CPI.

How the CPI is calculated?

 Many people believe CPI understates the actual inflation rate in the United States. On the other hand, some people believe CPI is not fully captured the impacts of technological deflation. So who’s right? 

Consumers paying for things in the real world are academics with models and numbers in front of them. This is the average American household expenditure, housing, transportation, health care, and education collectively a 60% of the spending, while everything else combined is 40%. According to the official metric, the median house price healthcare CPI and education and childcare CPI rose faster than broad CPI. If 60% of the expenditure basket increases higher than the overall inflation rate, does that outweigh the remaining 40%? One conflict of consumer price inflation involves the calculation of housing costs. Housing is one of the most significant expenses for consumers and calculating costs plays a huge role in CPI is accuracy. CPI excludes house prices since it is considered a capital asset. A capital asset is an investment that earns income or capital gains. CPI measures consumption assets, which are goods and services that do not get resold. Instead of house prices, the government uses owners’ equivalent rent, the calculation runs into a problem when deciding to include the interest rate in the home price when calculating its cost. Since the owner’s equivalent rent looks at the monthly cost, it indirectly considers interest rates.

Based on the data CPI reflects an average of 2.5% yearly price inflation for the past three decades. Factoring out some questionable parts of the model, a number around 3% is realistic. However, because the modern world requires more education and debt inflation feels like 4% annualized for many people. The broad money supply rose at 5% per year during this time but mainly concentrated in the assets of the upper class. You’ll often hear that inflation is transitory. Many types of inflation occur rapidly and then suddenly call off. Inflation that is transitory in absolute terms reflects prices temporarily increasing and then dropping back down when the supply shock is over. On the other hand, transitory inflation and rate of change terms describe prices that jump rapidly, then slow but never returned to original levels. Let’s look at the inflationary 1940s. The official year-over-year inflation rate shows three clear inflation spikes. These spikes were transitory and rate of change terms. prices increased then the cooled-off button never returned to its original levels. Inflation spiked because the broad money supply per capita soared in the 1940s. Once that money was created, it remained in the system forever, and prices reached permanently higher levels. Keep this in mind when told that inflation is transitory, it’s often transitory and rate of change terms, but not absolute terms, hyperinflation is defined as 50% month over month inflation, if that persists, and therefore compounds exponentially, that will be well over 10,000% inflation by the end of the year after World War One, the Weimar Republic Mark hyperinflated, due to losing the war and paying foreign war reparations, in 2016, the Venezuela Bulevar hyperinflated. There needs to be a widespread loss of faith in the currency from a collapse in oil prices and loose money printing policies for hyperinflation. With the economic structure in developed countries, hyperinflation is unlikely. in developing countries, hyperinflation has a higher likelihood of occurring. Since direct access to starting capital is limited developing nations must rely on foreign financing. These corporations or governments often owe debts in currencies that they cannot print, and default when failing to repay these obligations. hyperinflation negatively affects everyone since the economy can’t function properly. With no reliable medium of exchange, it isn’t easy to offer products and services, especially ones that require planning and investment. However, inflationary environments have winners and losers. 

Who benefits from inflation?

Whenever the balance of power shifts towards labor, monetary inflation is likely to translate into consumer price inflation. CPI should be questioned, as it is handpicked by the government and doesn’t reflect unique spending habits. The big loser asset classes in inflationary environments are cash, loans, bonds, and any fixed income. Put simply owning the debts of others assures a negative return. On the other hand, inflation is beneficial for debtors as their debt will be easier to pay off as inflation rises. When cash gets devalued a person’s time gets devalued. Understanding the basics of inflation will help more people protect their most important asset time.

Read also: Is a Stock Market crash coming in 2021?

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