Inflation

Example for inflation

Let's take a look at examples for inflation by looking at how it impacts:

• consumers
• producers

Inflation Example: Consumers

As a consumer, prices are a vital component of purchasing products. How might an increase in prices affect the way consumers purchase products?

Consumers cannot purchase the same number of products if their income stays the same. For example, if your income stays the same and prices increase, then your purchasing power is reduced. Therefore, you are left with two difficult options: purchase the same number of goods at higher prices or purchase fewer goods because of higher prices. This decision can become very difficult when it comes to essentials like food, housing, and healthcare.

Figure 1. U.S. Consumer Price Index for May, StudySmarter Originals. Source: Bureau of Labor Statistics

The graph¹ above shows the United States consumer price index (CPI) for the month of May year after year. As you can see, the CPI was hovering around 2% up to 2021 and 2022. The CPI grew at a rapid pace, indicating that the average market basket for consumer goods increased dramatically — inflation.

Inflation Example: Producers

As a producer, prices are a vital component of creating products for consumers. How might an increase in prices affect the way producers make products?

Producers will have to make decisions about their production if inflation occurs.

The rational choice for firms is to increase prices to cover their costs, but this would contribute to inflation. As you can see, firms have difficult decisions to make as well, just like consumers.

Inflation and Deflation

Inflation and Deflation are similar concepts but have clear distinctions. Inflation is the general increase in prices, whereas Deflation is the general decrease in prices. On the surface, deflation seems like a great thing, right? Imagine paying less than you were anticipating for your grocery bills, a car, or even a mortgage! However, deflation can also produce a deleterious outcome for consumers and producers alike.

When deflation occurs, the general prices are decreasing in the economy. If you know that your purchasing power will increase in the future, then you will save your money so that you can purchase more goods in the future. Why buy now if you can buy the same goods at a cheaper price later? This thought process is what makes deflation so dangerous. This will cause consumers to buy fewer products and producers to make fewer products, causing a slowdown in the economy and potentially a recession.

Inflation Causes

Inflation causes can be grouped by inflation type:

• demand-pull,
• cost-push,
• and built-in.

Demand-Pull

Demand-pull inflation occurs when there is an increase in total spending that exceeds economic production. You may have heard the term, "Too many dollars chasing too few goods." In essence, this is what demand-pull inflation is. This can occur from a central bank printing too much money in the economy when there are not enough resources to produce goods. The extra money bids up the prices for the few goods in the economy, leading to inflation.

Cost-Push

Cost-push inflation occurs when there are supply shocks in the economy. If there is an overall decrease in supply in the economy, then firms will have to increase prices to make up for the shortage. The decrease in supply can happen for several reasons, such as rising input costs, a decrease in resources, and a shortage of available labor. Anything that may increase the cost of production could lead to a decrease in supply, which could then lead to an increase in prices.

Built-in

Built-in inflation occurs when workers recognize that their wages are not keeping up with inflation rates. Workers will demand higher wages from their employers to keep up with inflation. Workers' purchasing power will not decrease if there is a commensurate increase in wages with inflation. When this occurs, firms will increase their prices as a result of increased wages, causing the prices of goods to increase in the economy. This cycle will continue and cause inflation.

Inflation Types

Let's go over the three main inflation types: inflation, disinflation, and hyperinflation.

Inflation

Inflation is the general increase in prices. Generally, the central bank (The Fed in the U.S.) is targeting a small amount of inflation each year — around 2%. This indicates a healthy and growing economy since consumers are purchasing products and producers are making products. This, inevitably, will cause prices to rise by a small amount each year. However, when inflation spirals out of control, it can pose problems for the economy.

Hyperinflation

Hyperinflation is the rapid increase in prices, categorized as an increase of 50% or more. Hyperinflation is dangerous because of the amount of uncertainty it has on the economy. Consumers and producers are heavily impacted — consumers struggle to purchase any products, and producers struggle to sell any products. The dollar's purchasing power becomes nearly meaningless, as it can barely serve as a medium of exchange. This is a dangerous position for an economy to be in and difficult to recover from.

Disinflation

Disinflation is the decrease in the inflation rate. For example, if the United States experiences 2.5% inflation in 2022 and 2% inflation in 2023, disinflation occurred. The issue with disinflation is that it could be a precursor to deflation. If the inflation rate keeps declining year after year, it could continue until there is deflation in the economy. Deflation can have devastating effects on the economy; as such, disinflation should be monitored closely to preclude deflation.