Why do prices rise? A deep understanding of the nature of inflation.

Definition and Core Mechanism

Inflation does not come out of nowhere. Simply put, it represents a decline in the purchasing power of a country's currency. When the prices of almost all goods and services are continuously rising, we say that this economy is experiencing inflation. This is different from mere relative price changes — the latter only involves a price increase of one or two specific goods, whereas inflation involves a wide-ranging price increase phenomenon across the entire economic system.

This process is not a short-term fluctuation, but a long-term, sustainable price evolution trend. Countries typically calculate the inflation rate annually, expressed as a percentage of the change in prices compared to the previous period.

The Three Major Causes of Inflation: Demand Pull, Cost Push, and Expectation Spiral

Demand side push up - demand exceeds supply

Imagine you are a baker. Normally, you can bake about 1,000 loaves of bread each week, just enough to meet market demand. But suddenly, as the economic situation improves, consumers have more disposable income, and the demand for bread surges.

What will happen at this time? Because your oven and manpower are already operating at full capacity, it is impossible to increase production in the short term. In the face of a supply-demand imbalance, some customers are willing to pay a higher price to buy bread. Therefore, you raise the price. This price increase caused by excessive demand is known as demand-pull inflation.

Expand this scenario to the entire economy: when consumers generally increase spending, the demand for various goods such as milk, oil, and bread surges, leading to an overall rise in prices.

Cost-side Pressure - Rising Production Costs

Now let's change the scene. You have expanded the oven, hired staff, and the weekly production has increased to 4000 loaves of bread, with ample supply. But suddenly one morning, bad news arrives: this year's wheat harvest is extremely poor, and flour supply is severely insufficient. To purchase enough flour, you have to pay a higher price.

The cost of flour has skyrocketed, and you must raise the price of bread to maintain profits—even though consumer purchasing desire has not increased. This is cost-push inflation.

On a macro level, this type of inflation is often triggered by resource shortages (oil, agricultural products), government tax increases, or the devaluation of the local currency (making imported goods more expensive).

Expectation-driven - Spiral ascent

Inflation has a third form: it can be self-reinforcing. When inflation persists in the economy, employees and businesses begin to expect prices to continue to rise.

Employees negotiate higher wages with employers to protect their purchasing power. In response to higher labor costs, companies raise product prices. This, in turn, drives up prices further, prompting employees to demand even higher salaries—creating a self-reinforcing price-wage spiral that perpetuates the spread of inflation.

Policy Response: Interest Rates, Fiscal and Monetary Control

When inflation spirals out of control, the government and central bank must intervene. They mainly rely on two tools:

The leverage effect of raising interest rates

When the central bank raises interest rates, borrowing becomes more expensive. As a result, consumers are more inclined to save rather than spend, and businesses may delay investments due to increased financing costs. Aggregate demand decreases, and the rate of price increase slows down.

This method is effective, but the cost is that economic growth may slow down—because both businesses and individuals are cutting back on spending and investment.

Trade-offs in fiscal policy

Another approach is to adjust government spending and taxation. If the government raises income tax, disposable income for residents decreases, leading to a decline in market demand, which theoretically can alleviate inflationary pressures. However, this approach is politically sensitive—public sentiment is often against tax increases, which can easily provoke social discontent.

How to measure inflation?

To control inflation, it must first be measured. Most countries use the Consumer Price Index (CPI) as this standard tool. The CPI tracks the prices of various consumer goods and services and constructs a representative basket of goods through a weighted average method, reflecting the purchasing patterns of an average household.

For example, taking a certain year as a benchmark (index value = 100), if the CPI rises to 110 two years later, it means that the average price has increased by 10% during these two years. The U.S. Bureau of Labor Statistics and other agencies regularly collect data from stores nationwide to ensure the accuracy of the calculations.

The Dual Nature of Inflation: Not an Absolute Evil

At first glance, inflation seems like a scourge that must be completely eradicated. But the reality is more complex.

the benefits of moderate inflation

Promoting Consumption and Investment: With moderate inflation, holding cash is actually a loss—because money will depreciate. This encourages consumers and businesses to take action immediately, rather than waiting for prices to continue rising.

Expand Corporate Profits: Companies can raise prices to offset cost pressures. If the reasons are sufficient, they can even increase prices by more than the cost growth, achieving profit expansion.

The Superiority of Deflation: The opposite of inflation is deflation—prices continue to fall. In this environment, consumers tend to postpone purchases (hoping to buy cheaper later), leading to a sharp decline in demand. Historically, periods of deflation are often accompanied by high unemployment rates. While moderate inflation erodes personal wealth, deflation causes greater harm to economic growth.

The dangers of excessive inflation

Currency Devaluation and Hyperinflation: Poorly controlled l'inflation can evolve into hyperinflation—monthly increases exceeding 50%. A basic necessity that originally costs 10 dollars may cost 15 dollars weeks later. Out-of-control prices can destroy confidence in the currency, plunging the economy into chaos.

Uncertainty Suppresses Growth: In a high inflation environment, businesses and individuals feel uncertain about the future direction, leading them to become cautious, reduce investments and spending, which in turn slows down economic growth.

Controversy of Policy Intervention: Some advocates of the free market oppose the government's attempt to “print money” (the so-called “Brrrrr” phenomenon) to control inflation, believing that it goes against economic laws.

Conclusion

Inflation is a norm in the modern fiat currency economy. If managed properly, it can stimulate economic activity; if out of control, it can cause serious damage. The most effective response today seems to be a flexible combination of monetary and fiscal policies, allowing governments and central banks to adjust according to the situation to maintain price stability. However, these tools must be used cautiously, or attempts to treat inflation may worsen the economic ailments.