Since the beginning of 2021, we are witnessing a significant rise in inflation globally, marking the first noteworthy inflation in years. Entire generations, who have not experienced inflation in their lifetime, are now confronted with it. But what does inflation mean, how does it occur, and what are its implications on the economy and consumers?
What is Inflation?
Inflation refers to the increase in the price level of goods and services in an economy over a specific period. In simpler terms, money loses its purchasing power as one needs to pay more to obtain the same goods and services. For instance, if a television costs 1,000€ in 2022 and the same television costs 1,100€ in 2023, the annual inflation rate [for that television] would be 10%.
However, inflation is typically not measured based on a single product but rather on a “representative basket of goods.” This basket reflects the consumption habits of the average consumers and includes various items from different categories, such as food, clothing, housing, healthcare, education, entertainment, and more. The idea behind a representative basket is to have a cross-section of expenses that people in a specific region actually incur. Once compiled, prices for the individual items in the representative basket are monitored at regular intervals. Changes in these prices are then used to calculate the Consumer Price Index (CPI), measuring how the average prices of goods and services in the basket change over time.
The composition of the representative basket is crucial for inflation calculation and often leads to discussions about the meaningfulness of reported inflation rates. It is essential, for example, that the basket adequately reflects changes in consumption habits (e.g., due to the introduction of new products and services) or that the weighting of individual goods and services accurately represents their actual contribution to the overall expenses of an average consumer (e.g., appropriate consideration of energy costs).
How Does Inflation Occur?
Inflation can be triggered or accelerated by various factors, which can be categorized as demand-pull and cost-push inflation:
- In demand-pull inflation, the demand for goods and services exceeds the supply. Due to the scarcity of supply, businesses can increase prices for their goods and services. Causes of such demand inflation can include increased consumption in households, growing government investment expenditures, or rising corporate investments. This additional demand, whether from households, the government, or businesses, can be triggered or accelerated by various factors. In this context, central bank monetary policies (e.g., European Central Bank) or the general interest rate level are often cited as significant drivers of demand. For example, if households can borrow “cheap” money due to low interest rates (i.e., low interest expenses), they are likely to do so and spend the money to buy goods and services.
- Cost-push inflation involves a general rise in the price level due to higher production costs for businesses, which are passed on to end customers. Higher production costs can arise for example from increased raw material and energy prices or wages. This increase in production costs can be triggered or accelerated by various factors. In Germany, for example, we experienced a rise in raw material and energy prices in 2022, attributed to the Russian invasion of Ukraine and the associated sanctions on gas deliveries. In response, companies passed on their increased production costs to customers, ultimately resulting in an inflationary increase. Another driver for cost-push inflation, which is highly relevant today due to the measures announced by the Trump administration, are tariffs. The effect of tariffs on inflation unfolds not only due to higher prices for end products imported from other countries, but also due to higher production costs for companies that need to import raw materials and semi-finished goods to produce their products.
Impact of Inflation
The immediate effect of inflation is a loss of purchasing power, meaning consumers can buy fewer goods and services for the same budget compared to a previous period. Therefore, inflation is also referred to as currency devaluation, as money becomes less valuable.
This currency devaluation particularly affects savers who hold money in cash or are invested in low-interest accounts. Due to the absence of returns or low returns on such forms of investment, savers experience a negative real interest rate during inflationary periods. This means that the inflation rate surpasses the nominal interest rate that the savers receive on their (invested) capital, resulting in a loss of purchasing power for the saver. Unlike cash or low-interest accounts, tangible assets such as stocks or commodities typically serve as effective instruments to protect money or assets from devaluation. This is because the value of tangible assets usually “grows” with the inflation rate, thereby avoiding negative real interest rates, and the purchasing power remains stable.
This can be illustrated with the example of an investment in stocks: A product that costs 1,000€ today would increase to 2,100€ within 30 years with an average inflation rate of 2.5% per year. This fundamentally has no impact on the real profit development of the company, since the nominal profit increases due to inflation-induced higher prices. If the company, for instance, achieves a profit margin of 15%, the profit per product would rise from 150€ to 315€ under otherwise unchanged conditions. Assuming that the stock of the company is valued on the stock market at ten times the profit, today’s stock price would be 1,500€. If the profit increases to 315€ in 30 years with unchanged profit valuation, the stock price would climb to 3,150€. The stock price would have more than doubled solely due to inflation, maintaining the purchasing power of money or assets over the 30 years.
Is Inflation Bad?
A moderate inflation rate of around 2% per year is generally considered a normal part of a healthy economy by most central banks. This is because moderate inflation encourages consumers and businesses to invest, as money will lose some value in the future (see the example above regarding stock investment). This, in turn, promotes economic activity.
However, higher inflation is viewed as unhealthy for the economy, as it implies not only the loss of purchasing power described above but also planning uncertainty for businesses (especially with volatile inflation rates).
Additionally, high inflation can lead to social impacts and redistributions. This is because different social groups may be differently affected by inflation. Lower-income segments are typically disproportionately higher affected by inflation, as they must allocate a larger portion of their income to basic needs such as food, rent, and energy, and typically hold fewer assets such as stocks or real estate to maintain their purchasing power (see the example above).
Measures to Reduce Inflation
Measures to reduce inflation can be categorized into monetary policy, fiscal policy, and supply-side measures:
- One of the most important monetary measures to combat inflation is the central bank’s increase of interest rates. Higher interest rates make borrowing more difficult, leading to a reduction in spending and investments, and consequently, demand. Therefore, an interest rate hike can result in an economic slowdown, placing central banks typically in the dilemma of balancing inflation control against economic cooling.
- Fiscal policy measures include reducing government investments or raising taxes to decrease aggregate demand and alleviate price pressure. Similar to interest rate increases, a potential economic slowdown must be considered here as collateral damage.
- In addition to monetary and fiscal measures, which mainly focus on the demand side, supply-side measures can also reduce inflation. These involve actions that increase the supply of goods and services to meet demand. Examples include improvements in productivity, facilitating access to the labor markets, free trade agreements, or measures to eliminate bottlenecks in the supply chain.
The effectiveness of these measures varies depending on the specific economic conditions and causes of inflation. Often, a coordinated application of multiple policy instruments is required. Credibility of policy is also a crucial factor: If economic actors are convinced that the government and central bank are genuinely combating inflation, this can lead to a more effective implementation of measures.
Conclusion
In summary, it can be concluded that inflation is a complex economic phenomenon with diverse effects on society and the economy.
While moderate inflation can be viewed as a normal component of a growing economy, creating incentives for spending and investments, high or unpredictable inflation rates can have significant negative consequences. Inflation leads to a loss of purchasing power, uncertainty for businesses, redistribution effects, and social impacts, especially for lower-income population segments.
Governments and central banks can implement various measures to combat inflation, including monetary, fiscal, and supply-side instruments. The effectiveness of these measures depends on specific economic conditions, and a coordinated use of multiple policy tools is often necessary. Credibility in policy actions is also crucial, as the belief among economic actors that the government and central bank are earnestly addressing inflation can enhance the effectiveness of implemented measures.
