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An Easy Guide To Understanding How Inflation Works

We often stumble across the term ‘inflation’ in the economic context. While we all have a basic gist about inflation and its repercussions, it can be difficult to define its effects and bottleneck. This term is a hot topic in the financial discipline and is taken quite seriously to dictate a country’s monetary status. With inflation on the rise over the past few decades, several governments are employing economists to control their rates and manage the effects. Contrary to popular belief, inflation is not necessarily always bad. While it can have some long-term repercussions, it also comes with several advantages. Follow this guide to understand how inflation works.

What is Inflation?

Simply put, inflation occurs when prices of goods and commodities rise. This means that a consumer’s purchasing power declines. Deflation, which is the opposite of inflation, occurs when prices fall and purchasing power increases. Over the years, the prices of any given currency have risen dramatically. However, as the prices of commodities rise, the living costs and salaries escalate as well. Certain government bodies monitor the changes in inflation and measure the rate to keep the economic situation smooth. The recorded data helps them control the rate. The rise is calculated in percentage and dictates the changes in price levels.

Causes of Inflation

Cost-push and demand-pull are two main causes governing the rise of prices and incline in the inflation rate. As the name suggests, prices of certain goods or services increase when consumers need or want them more. In other words, an increase in demand leads to higher prices. On the other hand, when the supply rate is low, prices increase as well, which is known as cost-push. In some cases, the money supply from the government’s end increases too, which is denoted as the third cause. Typically, the production capacity and processes of a country determine the cost-push and demand-pull rates.

Effects

The main issue brought by inflation is that money loses its value with time. For instance, if you buy a house for 100 gold coins today, you should be able to trade the same amount to get your house back. However, since money cannot be used as a unit, it loses its value and weakens even further with time. In the long term, hyperinflations can also affect house owners, SMEs, and government organizations as money may not be a great exchange tool or medium. Business owners prefer to trade or barter goods or services to avoid the use of money. When you use the money during inflation, you may not be able to pay for a product with an increased price.

Types of Inflation Indexes

Price indexes are assigned and calculated on the basis of the type of service or product used. The prices of some products have gone super low over the years, whereas certain services cost higher today. The effect and pattern will likely continue in the future. Different types of inflation indexes also differ in terms of the type of user or population, the type of product, and whether it is chained or unchained.

Personal Consumption Expenditure (PCE) Deflator

PCE Deflator refers to the index that is partially associated with GDP as well as the Fed. The chained index is one of the ways deployed by the PCE Deflator. The other one is the measurement of the prices associated with goods consumed by customers. Typically, consumers pay a specific price for a certain type of product, which is calculated and measured to determine the inflation rate. However, PCE Deflator takes a different type of approach by measuring the prices of the product or service.

Consumer Price Index- CPI

CPI is the most common type of inflation index of all. As the name suggests, CPI is the price that a consumer pays to fulfill their basic needs and wants. It includes medical care, transportation fees, groceries, food, etc. Any type of indirect costs or government payments is not included in CPI. This type of index covers ‘owners’ equivalent rent’, which gives you the ability to count an affordable rent rate and determine how the current inflation will impact your cost of living. In the United States, this index is often used with social welfare programs and Social Security to declare benefits.

Chained CPI

A detailed version of CPI is chained CPI, which documents monetary inflation with a better perspective. Today, most economists and policy circles agree that chained CPI should be deployed by every government to track the rates and control the ill effects of inflation. For example, if the prices of apples rise on an unchained index due to bad weather and resultant crop damage, the inflation can be rendered healthy. To demarcate this inflation rate as modest, chained CPI will also observe and mark the number of consumers who switch to eating other types of fruits but apples to compensate for the price surge.

Harmonized Index of Consumer Prices- HICP

HICP is a common term used by the Bank of England and the European Central Bank. This type of index covers basic benefits offered by government organizations and revolves around inflation occurring in Europe. Unlike CPI (which is also common in the United States), HICP also covers rural areas and ensures that every type of consumer can benefit from it. A statistical approach is also associated with a sampling method that improvises logistical issues and relevant difficulties. Europeans also pay less than Americans for healthcare and insurance premiums, which can impact price trends.

This easy-to-understand guide will surely have cleared all your questions and doubts related to inflation and its repercussions. As mentioned, inflation can be beneficial in some cases. For example, inflation can directly impact your tangible assets like stocks and property as they are not related to currency or liquidated money (until you sell them). With inflation in place, you can sell them at a higher price and earn a major profit. The same applies to bonds as well. From exporters to business owners and homemakers to working professionals, inflation can impact every individual in some way, especially if it is rising at an exponential rate. Educate yourself and familiarize yourself with inflation and its multiple aspects to balance your financial situation.

Angela Scott-Briggs

Editor, TechBullion.com | Interested in Innovations in Business, Finance, and Technology .

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Angela Scott-Briggs

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