Inflation for beginners

Inflation is just one of the many phenomena in Economics everybody is used to hearing over the news, and some people have an idea about what it is, but might not be too sure. Inflation has its many aspects, and I will try throughout this post explain to those who don’t have a background in Economics, but are interested to understanding a little bit more about it.

All the trades in an economy have at least two different aspects that define them: Quantity and Price. Economists love to talk about supply and demand, because they happen to be the two main forces that drive economy to an equilibrium: Consumers want to by more product for the smallest price they can get. Suppliers on the other hand, want to sell as much as they can, for the greatest value. We then have the demand curve negatively inclined and the demand curve, positively inclined.

The interception between the forces of supply and demand take the market to an equilibrium, where both sellers and buyers are happy with the amount of product traded for a certain price. And this happens in every market.

But as costumers, we don’t buy only one product, we buy many, and each of them has a different price, driven by a different market, which is the result of an equilibrium of supply and demand of buyers and sellers of each particular market.

When we talk about inflation, it doesn’t mean only the price of a certain product raised, it means there is a continuous and generalized raise in price throughout the economy, and it can happens for many reasons, but it is usually an indicator that something is out of balance in the economy.

Demand Inflation: This happens when people are willing to buy more than the economy is capable of producing. (For those of you who are studying Economics, remember your frontier of production possibility curve). If you are not studying Economics, this only means that even using all of the resources the economy currently has, it is still not enough to produce as much as people are willing to buy. This can occur by a number of reasons:

  • Too much credit: People getting easy access to credit, unlimited credit cards, this all accelerates demand, and make prices rise.
  • Low interest rates: When interest rates are low, it is not so good to save money, because you are not being rewarded enough for postponing consumption, and people tend to buy more.
  • Low investment in Fixed Capital: The industry needs investment, new machinery, new technology, to be able to catch up with consumption raise.
  • Central Banks emit more money than the economy needs, bills circulate faster, raising prices.

Cost Inflation: This happens when the price of a particular good, that is also input for the production of many other goods has its price raised for some reason, and since this affects many other products, there is a pass thorough of cost to other markets.

  • A Classic example of this was the oil crises on early and late 1970’s. Petrol is a very important input and feedstock for the economy. When its price raises, either for supply deficit of international political crises, the whole economy suffers.

So far, we have seen that inflation is caused by the economy trying to regain its balance after a shock. This can have multiple reasons, and depending on the reason, the approach to prevent or deal with it are different.

There is also the human anticipation factor of inflation, that can be extremely harmful and can quickly get out of control. When people know there is high inflation, they tend to anticipate their consumption of some goods, before the prices raise. But this only creates more pressure on the demand for products, and prices raise. Then people realize the prices raised, and they don’t want to wait for it to raise any further, so they buy before it raises again, and this vicious cycle can take an economy to a phenomenon known as Hyperinflation, when prices just go completely out of control, and the economy goes deeper and deeper into a recession, that increases social inequality and destroys welfare…..but that is a topic for another post.

 

Any further questions, please post them on comments, I will be happy to give you a follow up.

 

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