Understanding the mechanisms of inflation and its different types

Inflation is an economic phenomenon that everyone experiences on a daily basis. This prolonged increase in the cost of goods and services gradually reduces purchasing power. But did you know that this economic reality takes several distinct forms? Understanding the different expressions of inflation is essential for analyzing the current economy.

What is inflation exactly?

By definition, inflation represents the erosion of a currency's purchasing power. It is manifested by a lasting and widespread increase in prices across the entire economy, not just a simple variation in the prices of a few isolated products. This phenomenon is enduring – the increases must be sustained, not occasional.

Governments regularly measure this trend as a percentage, comparing price variations from one period to another. Contrary to what one might think, this measurement is not arbitrary: it follows the changes in households' consumption basket, reflecting the true impact on families' budgets.

The origins: how does inflation arise?

Basically, two main mechanisms trigger inflation. The first concerns excessive monetary expansion: when too much money circulates in the economy, each unit loses its value. The history of colonialism illustrates this phenomenon well: the massive influx of gold and silver from the Americas caused major inflation in Europe in the 15th century.

The second mechanism arises from supply disturbances. When a highly demanded product becomes scarce, its price rises, leading to a widespread increase in costs. This dynamic can spread throughout the entire economic system.

By deepening the analysis, economists distinguish several types of inflation according to their origin, a model conceptualized by economist Robert J. Gordon.

The three main types of inflation

Demand-pull inflation: when consumers spend too much

This type represents the most frequently observed form. Demand-pull inflation occurs when consumer spending exceeds available supply. Imagine a situation where economic conditions suddenly improve, giving consumers more purchasing power. If producers are unable to increase their output quickly enough, prices naturally rise.

A concrete example: in a manufacturing industry operating at full capacity, increasing production takes time. Companies need to build new facilities, recruit and train staff. Meanwhile, faced with excess demand, they can justify price increases. When this dynamic extends to several economic sectors simultaneously, demand-pull inflation sets in.

Cost-push inflation: the pressure comes from production

This form of inflation occurs when production costs increase – raw materials, labor, or taxes. Unlike the previous one, consumer demand has not changed, but producers are forced to pass on their increased costs to prices.

The causes are varied: failing crops reducing agricultural supply, increases in the government-mandated minimum wage, shortages of energy resources, or unfavorable fluctuations in exchange rates making imports more expensive. In each case, businesses must raise their prices to maintain their margins, propagating inflation.

Embedded inflation: the legacy of the economic past

Also known as “hangover inflation,” this form emerges from previous economic cycles. It crystallizes around two key concepts: inflation expectations and the price-wage spiral.

Economic agents – workers and businesses – develop expectations about future inflation based on past experience. If inflation has persisted, employees negotiate salary increases to preserve their purchasing power. Companies, faced with rising labor costs, increase their prices. This spiral reinforces itself: in the face of rising costs, workers demand even higher wages, creating a cycle that perpetuates.

How do authorities combat inflation?

Governments and central banks have tools to control runaway inflation. These interventions operate primarily on two fronts: monetary policy and fiscal policy.

The main weapon: increase interest rates

Central banks – like the American Federal Reserve – primarily control interest rates. Higher rates make borrowing expensive, which naturally discourages household spending and business investment. This reduction in demand slows the rise in prices.

The side effect: savings become more attractive. With higher interest yields, individuals prefer to build reserves rather than consume. Although beneficial for controlling inflation, this measure may hinder economic growth.

Fiscal adjustment: reducing disposable income

Governments can also modify their fiscal policy by increasing taxes. With less disposable income, consumers reduce their purchases, theoretically limiting overall demand. However, this approach remains politically delicate – the public often reacts negatively to tax increases.

The modification of the money supply

Central banks can also directly adjust the money supply. Quantitative easing (QE) injects money into the economy by purchasing assets, but this measure tends to increase inflation and is therefore not used during periods of high inflation. Its opposite, quantitative tightening (QT), reduces the money supply, but evidence of its effectiveness remains limited.

Measuring Inflation: The Consumer Price Index

To determine whether inflation needs to be fought, it is first necessary to measure it precisely. The preferred tool in most countries is the Consumer Price Index (CPI). This indicator tracks the evolution of a representative basket of goods and services purchased by households, using a weighted average to reflect actual consumption habits.

Statistical agencies – such as the U.S. Bureau of Labor Statistics – regularly collect this data from retailers to ensure the accuracy of calculations. By comparing the CPI score to a base level of (100 for the reference year ), and then to subsequent periods, one can precisely quantify the progression of prices. A CPI moving from 100 to 110 indicates a 10% increase over the considered period.

The benefits of moderate inflation

Paradoxically, inflation is not entirely negative. Moderate and controlled inflation stimulates the economy. It encourages consumers to spend quickly rather than hoard, knowing that their money will be worth less tomorrow. This increased propensity to consume supports businesses and investment.

For businesses, inflation creates a natural justification to raise prices. If they manage this dynamic well, they can even improve their margins by increasing rates more than strictly necessary.

Moreover, moderate inflation is preferable to deflation – the exact opposite. When prices decrease, consumers postpone their purchases in anticipation of better deals, reducing demand. This economic contraction historically coincides with high unemployment and a widespread saving mentality, hindering growth.

The dangers of poorly managed inflation

However, uncontrolled inflation poses serious problems. It erodes accumulated wealth: 100,000 euros stored today will not be worth the same in ten years against inflation. Individuals gradually lose their purchasing power.

Hyperinflation represents a catastrophe scenario. It manifests when prices increase by more than 50% in a month. In these contexts, a basic commodity that cost 10 euros a few weeks ago can suddenly be worth 15, and this spiral rarely accelerates naturally. Currencies disintegrate, and the economy paralyzes.

High inflation also generates paralyzing uncertainty. Households and businesses, unaware of the future trajectory, become cautious. Investments decline, growth stagnates. This atmosphere of unpredictability can become as damaging as inflation itself.

Finally, some criticize the interventionist role of governments in controlling inflation. Proponents of free market principles argue that the government's ability to “create money” contradicts natural economic mechanisms.

Conclusion

Inflation remains an unavoidable reality of modern economies based on fiat currency. If properly managed, it can support economic growth. If it escapes all control, it generates destruction and uncertainty.

The most effective solutions currently rely on flexible monetary and fiscal policies, allowing governments to quickly adjust their instruments in response to fluctuations. However, these policies require careful implementation – a clumsy intervention could risk exacerbating the problems it seeks to address. Vigilance remains essential.