Inflation
Episode #5 of the course Introduction to macroeconomics by Doha Soliman, CFA
Good morning and welcome to Day 5. As you are beginning to understand economics from a macro level, today, we’ll talk about the concept of inflation and deflation. In particular, we’ll explore why it is such an important topic to discuss and how it is measured and regulated.
What Is Inflation?
Inflation is simply a term used to refer to sustained periods of rising price levels over time. It is common knowledge that prices of all things have consistently increased year to year. We all have that older family member who likes to remind us of what they used to pay for everyday goods—for example, bread used to cost $0.30 per loaf and a salary of $10 a week used to be considered relatively well-off. So, you may be wondering: What causes this consistent rise in prices?
Well, the answer is not so simple. There are several factors that contribute to inflation. The two most common as defined by economists are demand-pull inflation and cost-push inflation.
Demand-pull inflation is a rise in the price level of goods due to demand that outpaces an economy’s capacity. For instance, if there is a very high demand for real estate in Canada and the capacity of the country does not meet this demand, this can result in bidding wars and thus, inflationary pressure on the real estate market. The second factor that can result in high inflation is when the prices of materials and resources utilized in production rise, which further results in higher finished goods or services. In continuing with our real estate example, if the minimum wage of contractors and builders goes up and the price of timber rises, there will undoubtedly be a higher premium on the housing market than there would be if the production costs were lower.
This brings us to an important question: How much inflation is considered healthy?
Measurement of Inflation
In order to answer this question, we must first address how inflation is measured. Like an economy’s output, there are several ways to measure inflation within an economy. The most common and utilized way is the Consumer Price Index (CPI). The CPI is essentially a year-to-year comparison of an actual basket of goods and services that consumers purchase regularly. The CPI data analysts poll thousands of families to determine what their regular purchases include and monitor those prices over time in order to calculate inflation.
For instance, the data analysts will call families and ask them what they purchase every week. They will record this information, find the common purchases, and add them to the CPI basket. If a statistically significant number of families purchases apples, they will add apples to the list of baskets of goods and services to be monitored for price fluctuations.
Inflation vs. Hyperinflation
While inflation is common and to be expected, hyperinflation can be detrimental to a country’s economy and structure. Hyperinflation occurs when a country’s central bank prints a large quantity of its money, resulting in a devaluation of its currency. To simplify, if you have a salary of $100,000 and that gives you a comfortable living, it is much more stable than if your salary was now $1,000,000 and you were living in poverty. If the central bank prints an excessive amount of money, the $1,000,000 example can occur, where everyone’s a millionaire but in reality, living within the poverty line.
A healthy inflation is generally defined as 1% to 2% in a stable economy. High inflation is in the double digits, whereas hyperinflation generally refers to inflation that exceeds 50%. Hyperinflation hastily deteriorates an economy’s sustainability and destroys the currency.
The role of government in setting the interest rate is the topic of tomorrow’s lesson, and we’ll cover it in more detail. Until then, keep in mind that inflation is healthy to a certain extent but can be detrimental if it reaches new heights at a fast rate.
Recommended book
Basic Economics by Thomas Sowell
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