What is inflation? Understanding inflation rates

Inflation is a very common term when it comes to the price movement of any country in the world. The high rate of inflation affects the overall economic health of a nation. A big increase in the cost of goods and services suggests inflation, which is a gradual loss of purchasing power.

The annual inflation rate is a key measure used to manage economic stability, with the U.S. government targeting a 2 percent annual inflation rate to ensure stable purchasing power and economic growth.

Over the past few years, inflation has been on the minds of many individuals. The U.S. had a spike in inflation of 9.1 percent in June 2022, which was the highest since February 1982. Since then, the rate of inflation has decreased in the UK, Europe, Japan, and the US, especially in the last few months of 2023, according to a report by McKinsey.

Measuring inflation consistently across countries is crucial, and the consumer price index (CPI) is a common method used to assess and compare inflation rates.

Definition of inflation

The term ‘inflation’ describes a long-term, widespread increase in the cost of products and services across the economy, which reduces both consumer and company purchasing power. Economic theory and practice, experienced over many years and in several countries, demonstrate that an easy monetary policy is a major contributing factor to extended periods of inflation. Putting it another way, inflation rises when a country’s central bank sets interest rates too low or increases money growth too quickly. Your dollar, or whatever currency you choose to use, will therefore not be worth as much today as it was yesterday.

Understanding high inflation rates

High inflation rates can significantly impact both the economy and individuals. When inflation rates soar, it means that prices are rising rapidly. And the purchasing power of money is diminishing. This scenario can lead to a decrease in the standard of living. This is because people find themselves able to buy fewer goods and services with the same amount of money. The rapid rise in prices can also create uncertainty and volatility in the economy. This makes it challenging for businesses and individuals to make long-term plans.

Several factors can contribute to high inflation rates. One major factor is an increase in the money supply. When more money is available in the economy, it can lead to higher demand for goods and services. That increases the prices. Additionally, a rise in aggregate demand, where the overall demand for goods and services increases, can also push prices higher as businesses respond by raising their prices. Conversely, a decrease in aggregate supply, where businesses are unable to meet the demand for goods and services, can also result in higher prices.

High inflation rates can disproportionately affect certain groups. These are low-income households and fixed-income earners. These groups may experience a more rapid decrease in their purchasing power. This is because they are less able to absorb the effects of rising prices. Understanding these dynamics is crucial for policymakers and economists as they work to manage inflation and its impacts on different segments of the population.

Countries with high inflation rates in 2024

Here is a table of the countries with high inflation:

Inflation rates

Source: International Monetary Fund, World Economic Outlook Database, April 2024

Factors causing inflation

Although inflation keeps showing its existence in the majority of the world’s economies these days, it can have many causes, which are below:

Cost-push inflation is a phenomenon triggered by increased production costs due to supply shocks, such as natural disasters or rising commodity prices, leading to elevated consumer prices that reflect these higher input costs.

Fuel inflation, specifically referencing the sharp rise in food and fuel prices in 2008, illustrates how increases in production costs, including high oil prices, can disrupt the supply chain and lead to inflationary pressures on the economy.

The economy is expanding

More people have employment, salaries rise to attract and retain workers, and consumer spending increases while the economy is expanding. They consequently purchase additional items and, in certain cases, indulge in upscale goods. In this scenario, businesses can increase their pricing, which means wholesalers can rise their prices as well. Overall price increases as a result of this expansionary cycle are known as inflation.

More money is available (increase in money supply)

Another way that inflation can happen is if the central bank prints more fiat money than the economy is expanding at a faster rate. As a result, there will be greater financial bidding on fewer goods and services. As an outcome, these goods and services will cost more.

The housing market

There have been ups and downs in the housing market over time across the globe. Prices for homes will increase if there is a demand due to an expansion of the economy. Ancillary goods and services that assist the housing sector are similarly impacted by the demand. Similarly, the demand for construction materials like steel and timber, as well as home-use nails and rivets, can rise as a result of the higher demand for homes.

Fiscal policy expansion

Governments can increase the amount of discretionary cash available to consumers and companies by implementing expansionary fiscal policies. Businesses can use tax breaks to fund capital projects, staff remuneration, or new hires. Additionally, consumers could buy more products. The government might boost infrastructure project expenditure as another way to grow the economy. One possible outcome is a rise in the demand for products and services, which would drive up prices.

Regional inflation trends

Inflation trends can vary significantly from one region to another. For instance, in the United Arab Emirates (UAE), consumer price inflation averaged 1.6 percent over the 10 years leading up to 2022, with a notable increase to an average of 4.8 percent in 2022. This figure is lower than the Middle East & North Africa regional average of 5.4 percent, highlighting the UAE’s relative price stability in comparison to its neighbors.

In Europe, inflation rates have been relatively low in recent years. The European Central Bank (ECB) has set an inflation target of 2 percent for the euro area and has employed various monetary policy tools to keep inflation within this target range. This approach has helped maintain price stability across the region, contributing to a more predictable economic environment.

Conversely, regions like Latin America have experienced high inflation rates in recent years. This trend has been driven by a combination of factors, including a rise in aggregate demand, a decrease in aggregate supply, and an increase in the money supply. These factors have collectively contributed to significant price inflation, affecting both consumers and businesses in these economies.

Understanding regional inflation trends is essential for businesses and individuals as it helps them make informed decisions about investments, pricing strategies, and other economic activities. By keeping an eye on these trends, stakeholders can better navigate the complexities of the global economy.

Global inflation forecast

According to International Monetary Fund, the global inflation is forecast to decline steadily, from 6.8 percent in 2023 to 5.9 percent in 2024 and 4.5 percent in 2025, with advanced economies returning to their inflation targets sooner than emerging market and developing economies. Core inflation is generally projected to decline more gradually.

As output disparities close, growth in the main advanced economies is becoming more coordinated. Following a robust 2023, there are growing indications that the U.S. economy is cooling, particularly in the labor market. In contrast, the euro area is about to rebound from last year’s almost stagnant performance.

The primary driver of the world economy continues to be the developing market economies of Asia. Revisions to growth indicate that China and India now provide over half of the world’s growth. However, the outlook for the next five years is still bleak, mostly due to developing Asia’s slowing pace of development. China’s growth is expected to slow down to 3.3 percent by 2029, a significant decrease from the present rate.

We predict that, similar to April, worldwide inflation will decline to 5.9 percent this year from 6.7 percent last year, roughly following a trajectory towards a gentle landing. However, the U.S. and other developed countries have seen a slowdown in the fight against inflation, and there are signs of improvement.

How inflation affect consumers and companies differently

Inflation impacts consumers and companies in distinct ways. For consumers, inflation often leads to a decrease in purchasing power. As prices rise, the value of money diminishes, making it more challenging for individuals to afford the same goods and services. This effect is particularly pronounced for low-income households and fixed-income earners, who may see their standard of living decline as a result of rising prices.

For companies, inflation can lead to increased costs. As the prices of raw materials and other inputs rise, companies may find their profit margins squeezed. This situation can be exacerbated if companies are unable to pass on the full extent of these price increases to their customers. Additionally, companies may experience a decrease in demand as consumers become less able to afford their products and services.

However, some companies may benefit from inflation, especially those that can successfully pass on price increases to their customers. Businesses that produce essential goods and services, such as food and healthcare, may see an increase in demand, as consumers are less likely to cut back on these necessities.

Inflation can also lead to changes in consumer behavior. As people seek to protect their purchasing power, they may prioritize spending on essential items and reduce expenditures on discretionary goods. This shift can create opportunities for companies that offer products and services deemed essential by consumers.

Overall, the impact of inflation on consumers and companies depends on various factors, including the level of inflation, the state of the economy, and the specific industry or sector in which they operate. Understanding these dynamics can help both consumers and businesses navigate the challenges posed by rising prices.

How inflation affect consumers and companies differently

Although consumers are most directly impacted by inflation, companies can also be affected:

• When the cost of goods like food, utilities, and petrol rises rises, consumers’ purchasing power decreases. This can cause households to tighten their belts and become increasingly pessimistic about the economy.
• Nominal interest rates play a crucial role in this dynamic, as they can influence real income and purchasing power. In an inflationary environment, higher nominal interest rates can erode the real income of consumers, particularly those with fixed incomes or debt obligations.
• When the cost of manufacturing inputs rises, corporations run the danger of losing buying power. And experiencing a drop in their profits. These can include completed machinery, intermediate goods like steel and grain, and raw resources like coal and crude oil. As a result, companies usually increase the cost of their goods and services to compensate for inflation, which is then passed on to customers. Many businesses find it difficult to find the ideal balance between increasing prices to offset increases in input costs and making sure that they don’t raise prices so much that they suppress demand.

How companies can manage high inflation

Companies usually spend more for products during high inflation times, which reduces their profits. Increasing consumer prices is one strategy used by businesses to balance their losses and hold onto profit margins. But, if price hikes are implemented erratically, businesses risk harming their reputation with clients and decreasing sales, which will ultimately reduce the profits they were trying to retain.

Recovering the cost of inflation for a particular product, when executed correctly, can improve margins overall and build connections. Businesses may ADAPT (adapt, develop, accelerate, plan, and monitor) to inflation in five ways:

1. Customize deals and discounts, and make the most of non-price variables: This may entail extending the deadline for manufacturing or tacking on surcharges and delivery costs to expedited or low-volume orders.
2. Enhance the science and art of changing prices: Consider customizing pricing actions to take into consideration factors such as product qualities, consumer willingness to pay, and inflation exposure rather than making general price adjustments.
3. Make decisions 10 times faster: Create a ‘inflation council’ consisting of specialized, cross-functional decision-makers with a concentrate on inflation who can respond fast and can act faster on the inputs shared by customers.
4. Plan alternatives that go beyond price to cut expenses: Rethink a portfolio using ‘value engineering,’ and provide more affordable options in place of price hikes.
5. Follow through with vigilance on the execution: Establish a central support staff to deal with income leakage and strictly monitor performance. When inflation is strong, traditional performance measurements may not be as trustworthy.

Read more | How to build business credit: Here’s what you should know

Advantages and disadvantages of inflation

It is possible that you think inflation is detrimental to the economy. Nonetheless, it is an unavoidable aspect of the economy that comes with pros and cons. Let take a look at both of them:

Pros

• A moderate rate of inflation indicates an economy in good health.
• A higher rate should theoretically enable manufacturing, which calls for greater work. Both employment and manufacturing opportunities increase as a result of this.
• It is easy for debtors to repay debts using money that is less valuable than what they originally borrowed.

Cons

• Uncertainty brought on by high inflation rates discourages investment. Higher inflation rates are typically associated with lower investment rates and, thus, slower economic development.
• Increased inflation lowers the current account balance of payments and exports. More inflation also results in more unemployment.
• It may also have an effect on the life of others, including elderly folks who depend on money.

How to measure inflation

Consumers’ cost of living depends on the prices of many goods and services, and the share of each in the household budget. To measure the average consumer’s cost of living, government agencies conduct household surveys. This is to identify a basket of commonly purchased items and track over time the cost of purchasing this basket. Housing expenses, including rent and mortgages, constitute the largest component of the consumer basket in the U.S. The cost of this basket at a given time expressed relative to a base year is the consumer price index (CPI), and the percentage change in the CPI over a certain period is consumer price inflation, the most widely used measure of inflation. For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10 percent over the period, as explained by IMF.

Another important measure of inflation is the producer price index (PPI). This indicates the average change in selling prices received by domestic producers. Unlike the CPI, which reflects price changes from the buyer’s perspective, the PPI reflects price changes from the seller’s perspective, making it crucial for economic analysis.

Core consumer inflation focuses on the underlying and persistent trends in inflation by excluding prices set by the government, and the more volatile prices of products. These include food and energy, most affected by seasonal factors or temporary supply conditions. Policymakers also watch core inflation closely. Calculation of an overall inflation rate — for a country, say, and not just for consumers — requires an index with broader coverage, such as the GDP deflator.

The CPI basket is mostly kept constant over time for consistency. However, it is tweaked occasionally to reflect changing consumption patterns. For example, to include new hi-tech goods and to replace items no longer widely purchased. Because it shows how, on average, prices change over time for everything produced in an economy, the contents of the GDP deflator vary each year and are more current than the mostly fixed CPI basket. On the other hand, the deflator includes non-consumer items (such as military spending). And, is therefore not a good measure of the cost of living.

Role of central banks in managing inflation

Central banks play an important role in controlling inflation. To regulate the money supply and interest rates, they put monetary policies into effect. Through their control over interest rates and the flow of money, central banks aim to stabilize prices and promote economic expansion.

Interest rate alterations: Central banks use interest rate changes as a common tool to control inflation. Interest rates may rise in response to rising inflation in order discourage borrowing and spending. This can help control demand and bring down prices. In contrast, during economic downturns, lower interest rates can promote borrowing and spending to boost demand.

Policies for exchange rates: Exchange rate policy can influence inflation, particularly in economies that depend significantly on imports. Reduced import prices can lead to lower inflation when the currency is stronger. On the other hand, bigger import prices can result in increased inflation if the value of the currency declines. Central banks can moderate the rise in prices of goods and services. This can be done by controlling exchange rates through their intervention in foreign currency markets.

Conclusion

One basic economic factor that affects many facets of our life is inflation. Rising prices are just one aspect of the intricate collaboration of forces impacting economies, people, companies, and governments. Gaining knowledge about its sources, impacts, and management techniques will certainly help to better understand how economies function and change over time.

Frequently Asked Questions (FAQs)

How does inflation benefit from higher interest rates?

Given that borrowing becomes more expensive as interest rates rise, higher rates may aid in reducing consumption. Additionally, people could be more likely to save more money. This is in order to benefit from higher rates, which would also reduce demand and relax the economy.

How soon does inflation return to average levels?

In the past, inflation cycles have lasted several years or a few months. The genesis of a specific inflationary episode as well as general economic factors determine how soon inflation declines. Changes in employment statistics, fluctuations in interest rates, and supply overshooting demand are some of the variables that might affect inflation.

Which three factors lead to inflation?

Demand-pull (demand surpassing supply), cost-push (increasing manufacturing costs), and built-in wage-price spirals are the three primary reasons of the boom.

What three categories of inflation exist?

Deflation/disinflation (slowing of prices), hyperinflation (fast and intense), and mild/moderate inflation are the three forms of inflation.

Who benefits from inflation?

Inflation benefits those with larger debts since the money they are spending to pay down their home or vehicle loan is now worth less than what they borrowed. Those whose employment have become more secure due to increased demand can also profit.

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