Understanding inflation: beyond just the simple increase in prices

Introduction: Why Your Purchasing Power Erodes Every Year

Have you noticed that your groceries are getting more and more expensive? Or that the prices of services seem to be rising regularly? Behind these everyday observations lies a fundamental economic mechanism: inflation. Often misunderstood, it represents much more than a mere fluctuation in prices. The most accurate definition of inflation would be: a gradual reduction in the purchasing power of a given currency, resulting from a sustained and generalized increase in the prices of goods and services in an economy.

Contrary to what novices might think, inflation is not simply the increase in the price of a particular product. Rather, it characterizes a long-term trend affecting nearly all goods and services in an economy. It is a systematic phenomenon, not an isolated event. Governments carry out regular measurements to track this evolution, generally expressed as a percentage of annual change.

The three engines of inflation

Inflation does not arise out of thin air. It results from specific economic dynamics that we can categorize into three main types according to the model of economist Robert J. Gordon.

When demand exceeds supply

Demand-pull inflation is the most common form. Imagine a bakery capable of producing a thousand loaves of bread per week. Everything runs normally until the day the customer base doubles. Consumers suddenly have more income to spend and buy more. But the ovens cannot magically produce two thousand loaves. Faced with this relative shortage, the baker raises his prices. Some customers are willing to pay more to get their bread. Multiply this scenario across all sectors of the economy – bread, milk, gas, housing – and you get widespread inflation. This is what happens when economic conditions improve and individuals spend more than there is supply available.

When production costs rise

Cost-push inflation works on an inverse logic. The baker has finally built new ovens and hired additional staff to produce four thousand loaves of bread weekly. The balance seems to be achieved. Then comes the bad news: the wheat harvest has been disastrous and regional stocks are depleted. The price of wheat skyrockets. To obtain his raw material, the baker must pay much more. He has no choice but to pass these costs onto his customers by raising the price of bread, even though demand has not changed.

On a large scale, cost-push inflation results from shortages of critical resources, government tax increases, or currency depreciation ( making imports more expensive). This is particularly visible during energy crises or commodity shocks.

Embedded inflation: the lasting effects

Embedded inflation, sometimes referred to as “hangover inflation,” emerges from past economic phenomena. It is triggered when the two previous forms persist, creating inflationary expectations. Once inflation has set in, workers expect it to continue. They negotiate for higher wages. Businesses, seeing their costs rise, increase prices. Workers, noticing that the cost of living is rising, again demand increases. This is the price-wage spiral: a self-reinforcing cycle where everyone protects their wealth by further fueling inflation.

How Governments and Central Banks Respond

Uncontrolled inflation destroys economies. This is why financial institutions have tools to contain this phenomenon.

The weapon of interest rates

The most direct method is to raise interest rates. More expensive borrowing discourages households and businesses from spending or investing. Demand decreases, easing inflationary pressure. Saving becomes more attractive since the offered interest is higher. However, this approach also slows economic growth, with businesses hesitant to launch new projects and individuals forgoing major purchases.

Adjust budget policies

Another option lies in modifying budgetary policies. If the state increases income taxes, households have less money to spend, mechanically reducing demand. Governments could also cut their own expenditures. However, this policy route is delicate: taxpayers rarely accept tax increases without protest.

Measuring Inflation: The Price Index

To combat inflation, it is essential to first measure it accurately. Most countries rely on a Consumer Price Index (CPI). This indicator tracks the price changes of a representative basket of goods and services purchased by households: food, clothing, housing, transportation, etc.

Statisticians regularly collect these prices from retail businesses to establish a weighted average. A base CPI of 100 ( reference year ) can become 110 two years later, meaning a 10% increase in prices over the period. This tool allows for easy comparison of changes from month to month or from year to year.

The Hidden Faces of Inflation: Advantages and Risks

Inflation presents a paradox: it is necessary in small doses, but destructive in excess.

When inflation plays a beneficial role

Moderate inflation encourages individuals and businesses to spend and invest rather than hoard. Why keep your money under a mattress if it will lose value tomorrow? It makes more sense to buy an asset now. This psychology stimulates consumption and investment, which are the engines of economic growth.

Companies also benefit from this dynamic. They can sell at higher prices and, if they manage to justify these increases, achieve additional profit margins.

Moderate inflation is also preferable to its exact opposite: deflation. When prices fall, consumers postpone their purchases in anticipation of further declines. Demand collapses. Businesses cut production and jobs. Historically, deflationary periods have coincided with high unemployment and economic stagnation.

The dangers of uncontrolled inflation

But finding the right balance proves difficult. Excessive inflation quickly erodes wealth. One hundred thousand dollars saved today will have lost a significant portion of their purchasing power in ten years. Hyperinflation, where prices rise by more than 50% per month, creates economic chaos: a basic necessity that cost ten dollars last week may be worth fifteen dollars today. The currency itself loses all credibility.

High inflation also generates uncertainty. Businesses and households become cautious, reducing investments and spending. Growth stagnates. Moreover, some criticize government intervention to control inflation, arguing that “money creation” (a phenomenon known in cryptocurrency circles) violates the principles of a free market and disrupts natural economic balances.

Conclusion: A delicate balance to maintain

The definition of inflation can be summarized as an unavoidable reality of modern economies: the gradual increase in the cost of living. This phenomenon is neither good nor bad in itself. When well managed, it encourages spending and growth. When poorly controlled, it destroys wealth and economic order.

Today's governments rely on combinations of flexible monetary and fiscal policies to tailor their responses to circumstances. Raising rates, adjusting taxes, monitoring indices: these are all tools to preserve stability. These decisions require constant prudence, as each intervention carries the risk of creating new problems while solving the old one.