Debitoor's accounting dictionary

Inflation - What is inflation?

Inflation is an economic term used to describe the rising prices of goods and services over time.

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Inflation impacts the cost of living by affecting everything around you, because as prices of goods and services rise, your money buys less. This means that you have to spend more to buy the same milk carton, or to fill up your gas tank. The value of money becomes less, which affects our purchasing power as consumers.

The purchasing power of every unit of currency is reduced when inflation occurs. To put it another way, your savings today can easily deteriorate or become less valuable tomorrow when a rise in inflation occurs. A main example of this, is apartment or housing prices. As a result, the standard of living becomes reduced over time.

What causes inflation?

There are several different factors which can cause inflation, but the two main causes are demand-pull factors and cost-push factors.

Demand-pull inflation Demand-pull inflation stems from an economic growth and occurs when aggregate demand is growing at an excessive rate, higher than the aggregate supply. This puts higher pressure on scarce resources, and as producers and firms reach their full capacity, they respond to the increase in demand by increasing their price level, resulting in inflation.

Another factor to think about with demand-pull inflation is that as firms produce more, they also employ more workers, ultimately lowering the unemployment rate. However, an increased demand for workers puts pressure on increasing wages. Higher wages lead to an increase in consumer income and therefore an increase in consumer spending.

Cost-push inflation Where demand-pull inflation is an issue of demand being greater than production capacity, cost-push inflation is an issue from the supply side.

Cost-push inflation occurs when there is an increase in the price of production process. This can be due to several different reasons. An increase in production costs forces producers and firms to increase their price level, to counter the increase in production costs.

For example, a rise in the price of raw materials (for example oil or energy) causes an increase in the cost of producing and transporting goods. When production costs increase, the aggregate supply level decreases, causing an overall increase in price level.

Another factor causing an increase in production costs is wage increases. When wages rise, so does the cost of labour. Wage costs often rise when the unemployment rate is low, because a low unemployment rate signifies that the demand for labour is higher than supply. Hence, employers need to attract employees by paying higher wages, and often the result is that the wage increase is greater than the improvement in productivity.

Other factors causing inflation

Where demand-pull and cost-push inflation are the two main types, there are a number of other factors which also cause inflation. These factors can arise from both internal and external events.

For example:

  • An increase in VAT rate can cause an increase in a firm's production costs, leading to an increase in domestic inflation.
  • A depreciation in exchange rate is likely to cause an increase in inflation, because this means the currency buys less foreign exchange. If the exchange rate depreciates, the price of imported goods becomes more expensive to buy from abroad, also resulting in a higher demand for domestic products.

The spiral effect & monitoring inflation

As you can already see, inflation tends to cause a spiral effect. Once inflation sets in, it can be difficult to reduce it or experience deflation. In fact, inflation tends to be self-serving, meaning if people expect high inflation, that's usually what will happen.

Imagine this, if you (as an employee) expect an increase in inflation - and therefore increase in prices - you are likely to demand a higher wage. This higher wage however will only lead to cost-push inflation. And here we have the spiral effect.

However, before we start to worry you into thinking that inflation is a never-ending downwards spiral, keep in mind there are of course policies in place that aim to stabilise inflation!

It is the central bank's responsibility to monitor inflation and enforce the necessary monetary policies. These monetary policies affect the level of money supply into the economy by either increasing or decreasing the money supply in order to maintain a stable and balanced economy as much as possible.

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