What Is Inflation?



Inflation is the increase in the price of goods and services in an economy, over a set period of time. For that reason, inflation is also defined as the reduction of purchasing power of a given currency. Several specific conditions make up inflation. 

First, the rise in prices has to be sustained and not just a sporadic event. While prices may go up suddenly on an item, this may not necessarily be inflation. These are called “relative-price changes” and often occur due to a problem with supply and demand of a particular good. Once the supply increases to meet demand, the price will stabilize. On the other hand, during inflation, the rise in prices continues without stabilizing.

Second, inflation involves a general increase in prices of goods and services. While “relative-price change” usually means just one or two goods have increased in price, inflation refers to an increase in costs of nearly all items in the economy. 

Third, inflation is a long-term phenomenon. The general increase in prices continues for an extended period of time. Most modern nations perform annual measurements of inflation rates, and studies reveal that inflation often stretches over several years.

How Does Inflation Work? 

Causes of Inflation

Economists have identified two basic causes of inflation. First, a rapid increase in the amount of actual currency in circulation (supply). For instance, when European conquistadors subjugated the western hemisphere in the 15th century, gold and silver bullion flooded into Europe and caused inflation.

Second, inflation can occur due to a supply shortage in a specific good that is in high demand. This can then spark a rise in the price of that good, which may ripple through the rest of the economy. The result can be a general rise in prices across nearly all goods and services.

Measuring Inflation

There are many different approaches to how inflation is measured. The usual method is to measure the prices of the most relevant goods and services. To perform such a measurement, government agencies may conduct, for example, household surveys that identify the commonly purchased items within a community or country. The prices of these items are then tracked over time and used as a base for the calculation.

Inflation vs. Deflation

Deflation is when there is a general decline in prices over a set period. Though inflation is often a threat to a nation’s economy, deflation may also be dangerous. 

First, deflation tends to slow down economic activity. As prices fall, consumers develop the habit of delaying purchases until prices are lower. Second, deflation can then cause businesses to reduce investing in improved production due to lower consumer demand. Finally, this translates into less demand for borrowing money, which leads to lower interest rates. While lower interest rates may help consumers who take out a mortgage or loan, it hurts the ones who live off of the interest earned from savings accounts. 

Followed by the Stock Market Crash of 1929, the Great Depression is one notable example of deflation. It is considered the largest and longest economic depression in modern world history. The economic contraction caused the money supply to reduce and started a downward economic spiral. The US unemployment rate raised from 3.2% to roughly 25% in 4 years, decreasing the demands for goods and resulting in even more unemployment. 

Economists term this sequence a deflationary spiral because one negative economic event leads to another. Often some type of financial crisis sparks the cycle by reducing demand for goods and services, which slows down production. This reduces wages and income, which in turn further curtails demand. The slowdown causes prices to drop. Once a deflationary spiral begins, the problems it creates can easily continue the downturn. Financial experts consider deflationary spirals to be a great threat to a nation’s economy. 

Inflation in Venezuela

A clear example of the impact of inflation is found in Venezuela. The South American country has seen its economy crumble under inflation over the last years. Socialist policies, widespread corruption, and falling oil prices are probably some of the major causes of Venezuela’s hyperinflation.

Why Inflation Matters?

Inflation is an important issue as it can have both positive and negative effects on a nation’s economy and a consumer’s personal finances. 

The Positive Aspects of Inflation

Though inflation is often very harmful, it can have some positive benefits. First, inflation can stimulate a nation’s economy. As more money circulates, there is more money to spend, which creates more demand. This spurs production, reduces unemployment, and puts more money into the economy as a whole.

Second, inflation protects against an economic danger called the “Paradox of Thrift”. This is a term coined by John Maynard Keynes, a famous 20th-century economist. It refers to the tendency of consumers to delay buying goods when prices are falling during deflation. As you can see, inflation works the opposite way of deflation – it prompts consumers to buy goods and services quickly before prices increase more. 

The Negative Aspects of Inflation

Though economists and government officials are rightfully concerned with inflation, it also matters for common citizens for several reasons. It hurts the most vulnerable people in a nation – the poor and the elderly and also decreases the real income of the working class. Third, it causes interest rates to go up. Finally, inflation reduces the value of savings. People who have spent years saving money to provide for education or retirement will see the buying power of that money greatly reduced. 

Cryptocurrencies and Inflation

While national governments try to control inflation, Bitcoin is seen by many as a good hedge against the ravages of inflation. This is due to the fact that Bitcoin has a fixed total supply of 21 million coins. Despite some controversies, many believe that this makes Bitcoin a deflationary currency, and therefore, resistant to inflation. For this reason, many Venezuelans have begun using Bitcoin or other cryptocurrencies to cope with the nation’s hyperinflation.