Inflation: its meaning, types, effects, and how to treat it

 Inflation is one of the most financial phenomena affecting economic and social systems. This article will explain the meaning and types of inflation, and will explain the effects of inflation on countries and individuals, then solutions to treat inflation or reduce its damage.

 Financial or economic inflation is a social and economic phenomenon whose emergence is related to a decrease in the purchasing power of a particular currency over time. The quantification of the rate at which this decrease in purchasing power occurs is reflected in the increase in the average prices of some goods and services during a certain period of time.

 This rise in the general price level, which is often expressed as a percentage, indicates that a currency is actually buying less than it was buying in previous periods. This phenomenon can be compared to deflation, which occurs when the purchasing power of money increases and the prices of goods fall.

 What is the meaning of inflation?

 While it is easy to gauge the price changes of individual products over time, human needs go beyond one or two of these products. Humans need a large variety of products as well as a wide range of services to lead a comfortable life, and they include a large class of goods such as food grains, minerals, fuels, utilities such as electricity, transportation, and services such as health care and entertainment. Inflation is used to measure the overall effect of price changes for a variety of products and services, and allows a single value to represent the increase in the level of prices for goods and services in the economy over a period of time[1].

 The meaning of inflation can be summarized in saying that when a currency loses some of its value, prices rise and its purchasing value decreases, which means that the consumer will be able to buy less goods and services than in the past. This decrease in purchasing power affects the general cost of living for the general public which ultimately leads to slower economic growth. The consensus view among economists is that sustained inflation occurs when the growth of a nation's money supply exceeds economic growth.

 An example of inflation, the meaning of inflation, the explanation of inflation

 To combat inflation, the relevant authorities take the necessary measures to manage the money supply and credit to keep inflation levels within permissible limits and to keep the economy running smoothly. Monetary theory is a popular theory that explains the relationship between inflation and the money supply of an economy. An example of this is that in the aftermath of the Spanish conquest of the Aztec and Inca empires, huge amounts of gold and silver flowed into the Spanish and other European economies, increasing the money supply. This led to a decrease in the value of money, which contributed to a rapid increase in prices. Inflation is measured in several ways depending on the types of goods and services being considered, and is the opposite of deflation which refers to a general decline in the prices of goods and services when the rate of inflation falls below 0%.

 Examples of inflation

 You can get your hands on a wide variety of examples of inflation in your daily life. For example, think of a commodity that you bought in the past for a certain price, but now you are getting it for a slightly higher price than it was before. This rise in the price of this commodity is a manifestation of inflation.

 Sometimes you may think that this increase in the price of goods, which occurs over time, is due to the scarcity of milk or the high cost of making it. In fact, and more correctly, this increase in prices occurs due to the decrease in the value of money due to inflation.

 Methods for measuring inflation

 • Consumer Price Index (CPI)

 One of the scales used to measure inflation. This index tracks fluctuations and increases in goods and services across a wide range of sectors, including transportation, gas, healthcare, food products, housing, and education. The Consumer Price Index tracks inflation rates, along with their impact on the cost of living and purchasing power. These numbers help statisticians and economists understand the overall health of the economy.

 • Producer Price Index (PPI)

 This indicator is another way to measure inflation. It tracks price changes and how they affect producers, including agricultural, livestock, chemical, and metal products. This is because the increase in these prices will lead to a transitional increase in selling prices to the consumer.

 • Wholesale Price Index (WPI)

 The wholesale price index is another method of measuring inflation, which measures and tracks changes in the prices of goods in the pre-retail stages. While the items used for measuring WPI vary from country to country, they often include items related to the product or wholesale. This includes, for example, the prices of raw cotton, cotton yarn, gray cotton goods and cotton clothing.

 To learn about the most important causes of inflation, see: Causes of Inflation and Factors Contributing to Its Occurrence

 The effects of financial inflation

 Inflation is not a new phenomenon. It has been around over the years and attempts to study and study its effects on a large scale have been in place ever since. In the following, we will present to you the most important negative and positive effects of inflation on the economy and societies.[2]

 negative effects of inflation

 • Money loses value

 This effect is considered one of the most negative effects of inflation because with the increase in the prices of products and services, money loses its value. For example, if you keep a dollar under your pillow for ten years from now, you will not be able to buy what you can buy with it today because of inflation. If we look at the value of the US dollar, for example, between 1980 and 2022, then we can see that the dollar has lost more than half of its value. In other words, today's dollar will enable you to buy half of what you could have bought with one dollar years ago, with its value declining over time. As a result of declining purchasing power, inflation is causing consumers to try to find a return on their capital. Instead of leaving money under the mattress, or in low-interest bank accounts, it incentivizes consumers to find better returns. This is lest the money saved will become worthless over time. At the same time, inflation creates greater pressure on companies to invest any surplus capital because any money that is not used loses value if it is not put to use in some way with inflation whether it is in the stock market or any other form of investment.

 • inequality

 Inflation can hurt lower-income families the most. They usually spend more than their income, so price increases usually take more of their income. For example, when the price of necessities such as food and housing rises, the poor have no choice but to pay. Increasing the price of food items by $10 a week, for example, has a more profound effect on a person who earns $12,000 a year, than a person who earns $50,000. One of the most important manifestations of inflation is that asset prices tend to rise. Assets like housing, stocks, and commodities like gold tend to outpace inflation. This increases inequality because wealthier families are able to own more assets. In other words, the prices of these assets tend to rise before ordinary goods such as bread, milk, eggs, etc. As a result, they end up with wealth that can buy them more goods and services than before. Whereas lower-income families have to spend more to get by. People with lower incomes tend to spend a higher proportion of their income, so they have less money set aside for the purposes of saving and investing in stocks, bonds, and other assets. Furthermore, they are unlikely to be able to invest in a high capital expenditure such as a home. The result is that those who are able to invest some of their income in “inflation-protected” assets such as stocks.

 • High borrowing costs

 High borrowing costs are one of the most severe effects of inflation on consumers from the poor or low-income classes. If you take out a $200,000 mortgage, you have to pay back that amount plus the interest rate. This loan may be for more than 25 years, at an interest rate of 5 percent. The total cost to pay in over 25 years would be more than $345,000. Sometimes, consistent and high levels of inflation may cause financial institutions to increase their interest rates in order to protect themselves from inflationary pressures. Conversely, debtors may find it difficult to obtain loans afterwards.

 • Increasing the cost of living

 With commodity prices rising, consumers will have to pay more for both basic necessities and luxuries. This may not necessarily be a problem if salaries and incomes rise in line with inflation. But if this does not happen, the consumer will suffer from high prices. In other words, he will have to spend a higher percentage of his income on the same amount of goods. What inflation also does is push taxpayers to impose higher tax rates, which means higher taxes for some. If things are not tried to adapt to the new living reality, the consumer will end up in a worse situation as a result.

 Positive effects of inflation

 • Increase levels of spending and investment

 As the level of inflation increases, it motivates the consumer to make more purchasing decisions. Instead of waiting until next year when a product will be more expensive, consumers rationally choose to buy now rather than pay more next year. For the average consumer, that means buying new cars, refrigerators, phones, and consumer goods. However, this often goes beyond consumer goods, as this also encourages consumers to find the best return on their money investment. When money begins to lose its value under inflation, it becomes necessary to "beat it" just in order to maintain the same purchasing power. For example, a consumer may have $1,000 in the bank, but earn only 1 percent interest. However, if inflation is constant at 3 percent, they are losing money on an annual basis instead of making money. Here, the consumer is generally left with two options, the option to do nothing and watch while his money loses its value, and the option to find rewarding investments to compensate for what the money loses in value. However, this is a huge risk because the average consumer may not have the knowledge or skill required to make good and rewarding investment decisions.

 • Asset prices rise

 Historically, asset prices rise more quickly than inflation. For example, long-term home prices have historically outpaced inflation. The S&P 500 has averaged a return of 10 per cent annually since its inception in 1926. This is 7 per cent above inflation. What happens during periods of constant inflation is that consumers and businesses move buying decisions forward and spend more quickly and they move their capital into illiquid assets like stocks, bonds, and real estate, and what often happens in fact is a mixture of the two. So the consistent inflationary environment is caused by high spending levels, as consumers push purchasing decisions forward. At the same time, we also see a rise in asset prices as a result of individuals moving their investments to illiquid assets that can better protect their money from the negative effects of inflation.

 • Reduced effective level of debt

 Whether it is a business, government or consumer, those with high levels of debt may actually benefit from higher levels of inflation. For example, a borrower may have an interest rate of 2 percent on his debt. If the inflation level is at 10 per cent, and his income increases at a similar rate, it means that they will pay off their debts at a low rate. Although this can be a positive effect of inflation for debtors, for individuals such as savers and institutions such as banks, it can actually constitute a significant loss. Banks lose because they receive interest levels below the rate of inflation.

 Read also: Best Investment Strategies

 Types of inflation

 The Keynesian school, which is a school that derives its intellectual foundation from the British economist John Maynard Keynes (1883-1946) and which focuses primarily on the demand factor as the main driver of the economy, distinguishes between two types of inflation.

 Cost-push inflation type

 Cost-push inflation, one of the most common types of inflation, results from general increases in production costs. These factors, which include capital, land, and labor, constitute the inputs needed to produce goods and services. When the cost of these factors increases, producers wishing to maintain their profit margins must increase the prices of their goods and services. When these production costs rise throughout the economy, it can cause consumer prices to increase throughout the economy, as producers pass on their increased costs to consumers. Thus, consumer prices rise due to higher production costs.

 Demand inflation type

 This type of inflation results from an increase in aggregate demand compared to aggregate supply. You can take a popular product for which the demand exceeds the supply level as an example. When this happens, the price of the product will increase. The theory in demand inflation is that if aggregate demand exceeds aggregate supply, prices will increase throughout the economy.

 Treating inflation and reducing its effects

 Inflation occurs when the economy grows as a result of increased levels of spending without a concomitant increase in the production of goods and services. When this happens, prices rise and the value of the currency within the economy is lower than it was before. There are many methods used to treat inflation; Some of them work well and effectively while others may have adverse effects. For example, controlling inflation through wage and price controls can cause a recession and this may cause job losses and higher unemployment. In the following, we will learn about the most important ways to treat inflation and how to help control it. [3]

 contractionary monetary policy

 It is one of the common ways to treat and control inflation by adopting tighter monetary policy. The goal of deflationary policy is to reduce the money supply within the economy by lowering bond prices and increasing interest rates. This helps reduce spending because when there is less money to go around, money holders prefer to keep and save their money rather than spend it. This also means that there are fewer loans available, which can lead to less spending. Reducing spending is important to treat inflation because it helps to stop economic growth and thus the rate of inflation.

 There are three main tools for implementing deflationary policy as a cure for inflation. The first tool is to raise interest rates through the central bank. The federal funds rate is the rate at which banks borrow money from the government, but in order to make money, they must lend it at higher rates. When the Fed raises the interest rate, the banks will have no choice but to raise interest rates as well. When the banks raise their rates, fewer people will want to borrow money because it costs more while the money accumulates at higher interest. This lowers spending levels, lowers prices, and slows inflation.

 Standby requirements

 This remedy for inflation is to increase the reserve requirement over the amount of money that banks legally have to keep on hand to cover withdrawals. The more banks are asked to back down, the less they can lend to consumers. If they have less money to lend, consumers will borrow less and spend less.

 Reducing the level of money supply

 This is the third way to treat inflation. It is based on reducing the money supply, directly or indirectly, by enacting policies that encourage a decrease in the money supply. The latter policy raises the exchange rate of the currency due to higher demand (through capital inflows if prices are rising compared to foreign rates), and thus increases the volume of imports and reduces exports. These two mechanisms will reduce the amount of money in circulation because the money will go from banks, companies and the pockets of investors into the pocket of the government, which can control what happens to it.