(Trends Wide Spanish) — Inflation and how it affects prices always generates conversation, although sometimes the technical terms make it seem difficult to really understand what it is and what it means for your life.
For this reason, at a time when inflation affects several countries around the world, here we explain everything you need to know to understand this phenomenon.
What is inflation?
Inflation is the term that indicates that prices increase over time and, therefore, purchasing power decreases.
In other words, inflation indicates how much the prices of goods and services have risen in a given time; when prices rise over time, your money decreases in value (known as reduced purchasing power).
In short, “inflation is the sustained and generalized increase in the prices of goods and services in an economy over time,” according to the Bank of Mexico (Banxico), the Mexican central bank that is in charge of preserving the value of the country’s currency.
A hypothetical example
Let’s take a hypothetical example. A kilo of chicken a year ago cost US$5 and now it is worth US$5.31 (that is, an increase of 6.2%, which was in fact the annual inflation in the US in 2021). This means that, if you had US$5 before, you could buy that kilo of chicken, but now the same amount of money is no longer enough. Why? Due to inflation: prices rose and your purchasing power decreased.
More clearly: before you could buy more things with the same money and now that purchasing power went down because, although you have the same amount of money, prices went up.
Here it should be emphasized that the above is an example to illustrate the rise in prices. In reality, the phenomenon of inflation is more complex.
What’s the matter? Banxico explains that one cannot speak of inflation when only the price of one or a few products rises, nor can one speak of inflation when the price rose only once and returned to normal a short time later.
As the definition says, to talk about the phenomenon of inflation, the increase in prices must be “sustained and generalized”, that is, it must be constant over time and cover the generality of goods and services in the market.
When there is inflation, prices go up on food, of course; however, you can also see increases in fuel or vehicles, for example. In fact, food, gas, gasoline and vehicles are among the groups that had the most price increases in the United States during 2021, since in October it registered an inflation of 6.2% in the last 12 months, the largest increase in more 30 years old.
What causes prices to rise when talking about inflation?
At this point we can talk about several scenarios:
- The increase in production costs. For example, if fuel prices go up, transporting products from one place to another becomes more expensive, so products have to increase in price to generate returns.
- The increase in wages can also contribute to raising prices and therefore contributes to the phenomenon of inflation. If employers pay their employees more, they may have to raise their prices to cover those labor costs.
- The increase in prices in the context of inflation can be generated when the demand for goods exceeds the supply. What does this mean? Let’s relate it to the previous point: if a worker earns more money due to a salary increase, this usually causes him to buy more things (an increase in demand); however, there are not as many products on the market to meet this growing demand. Therefore, as there are fewer products on the shelves but more demand for them, prices go up for the few products that are available (in colloquial terms, it is as if it were a competition to see who has more to pay).
- In addition to the two previous points, we can also find another: if there is more money in circulation, this causes demand to increase beyond what is available in the market (supply) and therefore prices rise.
How is inflation measured?
This depends on the institutions and methodology of each country. But it is possible to talk about some essential points for measurement.
- You have to track the price of thousands of products in the country.
- In the case of Mexico, for example, the monitoring is for more than 230,000 prices that are grouped into more than 283 categories (of which 82 are for products from the basic basket, such as eggs, tortillas, fruits, vegetables, etc.).
- Since the products and their price are identified, how much people spend on them is tracked.
- The monitoring of product prices and spending on them is usually weekly, fortnightly, monthly or annually, precisely to see their evolution over time.
- When you have the previous data, you can calculate how much the price has increased, if the increases have been constant and if it has been a general increase in all products. If so, we can talk about inflation.
Inflation is not synonymous with “bad”
We have already seen that the increase in product prices can affect people’s pockets, because if the product is more expensive than before and I have the same money, it will not be enough for me to make my purchases (less purchasing power or , which is the same, your money is worth less).
“If over time we see that the number of things we can buy with the same amount of money is decreasing, we have fewer possibilities to save and it is more difficult to invest in a business, this means that our money is worth less. That is to say, there is inflation”, explains Banxico.
However, we cannot say that inflation by itself is a bad thing.
Inflation is an economic phenomenon that responds to various factors, as explained above. When inflation is high, it is clear that it affects us.
But, when prices rise slowly over a given period, it is considered normal and even healthy for the economy (especially when there are salary increases), since there is a constant (and not excessive) purchase of products, which maintains the market dynamism and what causes economic growth.
hyperinflation and deflation
Countries usually have an inflation target for each year (which requires internal and external factors to meet). That of the United States was 2% for 2021 and, as is known, inflation has shot up to 6.2% until October, which has been reflected in damage to people’s pockets.
Here we speak of higher than normal inflation, but not out of control.
When inflation is out of control and rises too high, it is called hyperinflation, which “has its origin in the rapid and excessive growth of the money supply in the economy, which is not supported by an equivalent production of goods and services” , according to Banxico.
In short, it occurs when the production of goods and services is much less than the amount of money available. I have “a lot of money”, but no products. This means that the few products on the market increase their value disproportionately (because there are many people who are looking for that minimum amount of available goods) and, even if they have money, what I have is not enough for me because the price is very high.
The most representative case of this is Venezuela: the International Monetary Fund forecasts that inflation in the South American country for 2021 will be 2,700% (the worst in the world), or 225% per month.
Banxico points out that hyperinflation is usually spoken of when inflation is 50% or more in a month.
In the opposite case, we have deflation, which is when inflation drops significantly.
“The causes of this phenomenon can be several, but they are generally associated with reductions in the supply of money and in the demand for goods, although it can also result from greater production than required,” Banxico indicates.
This means that deflation usually occurs when less money is printed and the purchase of goods decreases. As there is less demand for products, more supply of these due to the increase in production and less money circulating, prices go down and your money is worth more. Seems like a good thing, doesn’t it? But in economics everything must be seen with a magnifying glass.
“If this dynamic (of low prices) continues, it can cause consumers to decide to postpone their spending in anticipation of lower prices, reducing the demand for goods and services, causing businesses to lower their prices even more, causing a vicious cycle. This can force companies to produce less, increasing unemployment. In this way, deflation can lead to an economic recession”, explains Banxico.