Inflation

What is inflation?

Inflation is the process of a sustained, significant rise in the general price level over a period of time. Inflation thus lowers the purchasing power of money which means that the real value of the money decreases. For example, something will cost you $10 today but in 10 years, that same product would cost you $13.

Inflation

There are a wide variety of definitions that can be used to describe the process of inflation. I prefer the definition mentioned above for 3 reasons:

1. The definition is neutral.

This definition is formulated on the basic symptom of inflation, price increases. This makes the definition neutral to the things that can potentially cause the price increases. For instance, there is said that one of the causes of inflation is that there is an increase in the amount of money. This some definitions state that inflation is "too much money with too little goods." With that definition, policies that was not created for inflation which was caused by increases in money supply, cannot be used. This can lead to governments trying to use policies which have not been created to reduce inflation. The neutral definition also makes it possible to look at all the possible causes of inflation. This creates a healthy basis for anti-inflation policies.

2.  The definition describes inflation as a process.

This aspect of the definition is very important to me because inflation isn't a once-off rise in price, it is a continuous process where the general price levels rise. Inflation refers to the process where the prices of most goods and services rise on a yearly(or monthly) process.

3. The definition describes inflation as a significant process.

Inflation has to do with significant rises in price. When prices only rise gradually, say 1% or 2% per year, it is doubtful that it is inflation. This rise in price can, for instance, be because of an improvement in quality of that specific good or service. It would then be wrong to say that the rise in price is a product of inflation.

Now that you know what inflation is, you are probably wondering how they calculate it.

How do they calculate inflation?

Inflation gets calculated by creating a basket of selected products and services to measure and compare the prices of those products over a period of usually a month or a year. This basket is used to calculate the Consumer Price Index (CPI). The value of these products is tracked over time and the price fluctuations then gets measured. When there is a continuous rise in the price of this CPI value, it shows what the inflation of that specific timeframe was.

You get different types of Consumer Inflation (calculated by the CPI) and you need to understand what the differences between them are. 

We can distinguish between three types of consumer inflation:

• Headline Inflation
• Core Inflation
• Administered Price Inflation

Headline Inflation

When calculating headline inflation, most countries only include things in the CPI basket from urban areas as the prices of other areas fluctuate more than that of urban areas. This then leads to inaccurate data. 

The things that are included in headline inflation are a lot of products essential to the people in the economy. Headline inflation is the broadest type of inflation as it looks at a lot of products in the economy.

Core Inflation

Core inflation is essentially the same as headline inflation. The only difference is that it excludes items from the basket which prices fluctuate too much. Core inflation also doesn't include products of which it's prices are influenced by government intervention and policies. This includes things like government services like water and electricity.

Administered Price Inflation

Administered Price Inflation refers to the things in the economy of which it's prices are controlled by the government.

Producer Price Index

Just like you can calculate inflation on the consumer end of things, it is also possible to calculate inflation at the producers' end. This is done very similar to how the CPI is calculated. A basket is created containing certain goods, the only difference is that this is determined by the price of the goods at its first important trade transaction. In other words, it is the price of the products when it leaves the factory for the first time.

The Producers Price Index (PPI) is important to determine whether the source of the inflation is because of something that happened on the production side or the consumer side of the economy. Certain things that happened in the production side of something can create inflation. There are a lot of things that cause inflation, and as you guessed it there are a lot of after-effects because of this.

We will look at some of these things in the next blog post by using the brick wall theory.

In that post, we will look at the CPI and the PPI in practical terms by looking at the brick wall as an example. You will not want to miss that post!

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