To fully understand inflation, it is important to understand that in a market economy, the prices of goods and services are constantly changing. Depending on economic conditions, some prices increase, while others decrease.
We speak of inflation when prices increase in an aggregate way, and not just the prices of a few goods and services.
Understanding inflation: the experts’ definition
Inflation is therefore characterized by a persistent increase in the average price of goods and services over a long period (several consecutive quarters). And this regardless of sectoral variations in activity.
It, therefore, translates in practice into a decrease in the purchasing power (the real value) of the currency.
To calculate this price increase, we measure the change in the average price level of a panel of goods and services most commonly consumed by households, weighted by their respective share in the total expenditure of these households. The following are retained for the calculation:
- everyday goods (food, electricity, gasoline, etc.)
- durable goods (clothing, computers, household appliances, etc.)
- personal services (hairdressing, insurance, rents, etc.)
The causes and consequences of inflation
The inflation level of each country depends a lot on its national economic characteristics. But also, and increasingly, the cross effects of a globally connected economy.
In addition, an inflationary situation can arise from different factors which combine with each other, such as:
- excessive increase in money supply
- demand for goods and services greater than the available supply
- rising prices of imported goods and/or raw materials
- increase in production costs (wages, raw materials, energy, etc.)
- structural increases (lack of competition, administered prices, etc.)
- and finally, psychological causes and anticipation phenomena that can generate an inflationary spiral
In practice, inflation modifies the context of financial relations between debtors and creditors bound together by a contract that extends over time. Since the currency loses its value, the contract becomes unfavorable to one or the other of the parties who did not anticipate this fall in value.
Inflation penalizes in particular:
- creditors who have failed to hedge against inflation
- holders of physical currency
- exporters ( who will find it more difficult to sell their more expensive products ) and all their suppliers
Conversely, inflation will promote:
- debtors ( who will ultimately reimburse less than initially expected )
- creditors who have managed to over-protect themselves against inflation
- asset holders ( as opposed to currency holders )
- stockholders ( when these were purchased before or at the start of a price increase )
- importers ( who will more easily sell foreign products whose price has no reason to increase as much ) and their customers ( who will spend less, in real terms, for the same product )
The means available to control inflation
To fight against excess and control the level of inflation in the long term, there are various regulatory tools. To be effective, this tool must be implemented in a coherent and coordinated manner :
- a central bank monetary policy aimed at adapting the level of money supply and the key rates to the objective of a low inflation rate, but not zero
- a fiscal and budgetary policy aimed at an optimal balance of supply and demand
- but also an exchange rate policy (appreciation or depreciation) favorable to the balance of the trade balance, which can go as far as changing the currency
- and finally, a policy of controlling or relaxing the level of prices and wages, including indexation or de-indexation measures
Understanding inflation is not simple: it is a complex phenomenon about which there is much controversy. And the debate is as much about the consequences as about the causes.
But beyond that, these controversies are mainly fueled by the questions asked about the measures taken to contain it. And consequently, on the degree of interventionism of governments and financial organizations concerned in the economic life of a country.
Because one of the major concerns with inflation is that it directly impacts the purchasing power of households. Consumers see this every time they go shopping. In addition, they often have a stronger perception of inflation than it actually is.
Why that? This is the notion of “perceived value”, as explained in this article from the ECB
Understanding inflation through the notion of “perceived value”
The notion of the “perceived value” of a product by the consumer may be different from its real value. Studies have shown that we unconsciously introduce different biases into the observations we make on prices:
For example, we easily notice price increases ( and tend to memorize them! ), But we often pay less attention to price drops.
We know by heart the price of our regular purchases (gasoline, bread, public transport …), but these have increased significantly in recent years. And so it seems to us that everything has increased in the same proportion, whereas this is not true.
Since inflation is the measured variation of a set of consumer prices of households, it suffices that one of the elements entering into the calculation (such as fuel, for someone who takes his car every day ) is a more important expense item in a household, so that “personal” inflation is perceived as heavy.
Inflation rates are calculated over 12 months, but our memory goes way beyond … And we tend to compare prices further and further away from those of today.
Finally, we often think that a price increase automatically means inflation. Except that sometimes this increase is justified by a real improvement in the quality of a product, which decreases the real effect of inflation.
Following the pandemic, among other consequences, a general decline in purchasing power is felt almost everywhere, sometimes aggravated by political choices also linked to an inevitable ecological transition.
Many countries have seen their inflation rate increase significantly: + 5% in the USA, nearly 3% in the eurozone as a whole.
The colossal stimulus plan of 3.500 billion dollars wanted by Joe Biden, yet planed by half on its social component, must already face the discontent of the Republicans who accuse it of fueling long-term inflation in the United States.
So is inflation good or bad for the economy? In reality, it all depends on his level …
Moderate inflation can promote growth by stimulating investment. High inflation will jeopardize growth and threaten jobs, and any competitiveness of an economy can collapse because of rising domestic prices.
Either way, in times of high inflation, and as an individual, it is essential to put your money in investments that perform better than inflation. And this is the case with our iPro Growth Fund.