Everything you need to know about Economic Inflation

Economic inflation is considered a sign of economic weakness that occurs in the economies of countries. It is characterized by changes in the general price levels of goods and services due to supply and demand, or increased costs. This phenomenon is the result of a combination of factors that impact both individuals and nations. Therefore, understanding the fluctuations that precede inflation and persist during it is essential to taking appropriate measures by governments and relevant institutions to deal with it, aiming to reduce its exacerbation.

What is Economic Inflation?

Inflation is the continuous rise in the prices of goods and services that individuals need daily, such as food, clothing, medicine, and housing. Inflation is measured by tracking changes in the cost of these goods and services over specific time periods (monthly or annually).

The measurement of inflation depends on a basket of goods and services, which varies by country. Therefore, the items used by the central bank to measure inflation may differ from those used by the government. Additionally, inflation rates serve as a measure of the decline in the purchasing power of money, calculated as a percentage increase in prices. In the case of a decrease in this percentage, it is called “deflation,” meaning a decrease in prices.

Types of Economic Inflation

Inflation is classified into several types based on the speed of price increases:

1. Creeping Inflation: This type of inflation is moderate, where prices increase by 3% or less annually. According to the Federal Reserve, this type is favorable for the economy, as it contributes to moderate economic growth. It encourages consumers to increase consumption to offset the future impact of rising prices.
2. Accelerating Inflation: This occurs when prices rise between 3% and 10% annually. It results in a significant increase in demand for essential goods, which exceeds the suppliers’ ability to meet the demand, leading to faster price increases than people’s ability to purchase.
3. Hyperinflation: A severe type of inflation where prices rise by more than 10%, causing economic chaos. Hyperinflation leads to a rapid decline in currency value and deters foreign investment, deepening macroeconomic instability.
4. Runaway Inflation: Occurs when prices rise by more than 50% monthly, which is very rare. Historically, this occurred as a result of government policies such as printing money to finance wars. Countries like Germany in the early 20th century and Zimbabwe in the early 21st century experienced this phenomenon.
5. Stagflation: Occurs when the economy faces stagnation (a decline in economic growth) while prices remain high, making it one of the most challenging economic conditions to address.
6. Core Inflation: This type measures the rise in the prices of goods and services excluding food and energy, as their prices tend to be volatile due to seasonal factors.
7. Price Deflation: The opposite of inflation, where prices decrease continuously.
8. Wage Inflation: Happens when wages rise faster than the cost of living. This typically occurs during labor shortages, where unemployment drops below 4%, or when labor unions negotiate significant wage increases.
9. Asset Inflation: Occurs in a specific asset sector, such as housing, oil, or gold, leading to abnormal increases in their value.
10. Gasoline Inflation: Gasoline prices often rise in spring, coinciding with the start of driving season in the United States. Political instability in some oil-producing countries may also cause gasoline prices to increase.
11. Oil Price Inflation: Occurs when the price of oil rises due to threats affecting supply or increased demand.
12. Food Price Inflation: Occurs when food prices rise significantly, such as a 6.8% increase.
13. Gold Price Inflation: Countries often accumulate gold as a reserve against inflation or deflation, causing its price to rise.

Causes of Economic Inflation

There are several causes that lead to economic inflation, including:

1. Money Supply: This is a primary cause of inflation, occurring when the money supply exceeds the level of economic growth. When the government prints more money, the amount of money in the economy increases while the supply of goods remains constant, leading to increased demand for these goods and thus rising prices.
2. National Debt: National debt causes inflation when governments need to raise taxes to pay off debts or print more money. Increasing taxes leads companies to raise their product prices to offset the increase in costs, contributing to inflation. Printing money increases the money supply, worsening the issue.
3. Wage Increases: When workers’ wages rise, their income increases, enhancing their purchasing power, which boosts demand for goods and services. This leads to higher prices to balance supply and demand.
4. Cost-Push Inflation: This type of inflation occurs when companies face increased prices for raw materials, forcing them to raise the prices of goods and services to consumers.
5. Exchange Rates: Exchange rates significantly affect inflation. As the value of the local currency falls relative to foreign currencies, the price of imported goods increases.
6. Profit Maximization: Inflation may rise due to companies increasing their product prices to boost profits.
7. Decreased Productivity: This type of inflation is associated with a decline in production by companies, reducing the supply of goods and leading to higher prices.
8. Increased Taxes: When the government imposes higher taxes, this results in higher prices for goods and services.

Inflation and Its Relation to Macroeconomic Components

Inflation is one of the most important economic phenomena that economists pay attention to due to its significant impact on both the national and global economy. Inflation affects most economic and social indicators, such as GDP, economic and social development rates, trade balances, government budgets, and the stock market, among other areas.

Key characteristics of inflation include:
• Price increases encompass all goods and services.
• Price increases are continuous.
Some economists view inflation as a growth driver, as it reduces consumption, increases savings, and encourages investment later. Higher prices also motivate producers to increase production, which boosts economic growth.
On the other hand, some consider inflation an obstacle to economic growth, as it leads to currency depreciation and reduced confidence in the local economy, negatively impacting savings and causing investment flight, leading to significant economic problems.

The Impact of Inflation on Currency Exchange Rates

Exchange rates involve converting one currency into another and are determined by the relationship between supply and demand for different currencies. The exchange rate is the value of one unit of the local currency against one unit of foreign currency. Exchange rates are divided into two types: fixed, which are set by the central bank, and floating, which are determined by market forces.

When inflation rises, the value of the local currency decreases in terms of purchasing power, meaning the national currency becomes less capable of purchasing the same quantity of goods compared to foreign currencies. As a result, the number of units of the national currency required to exchange for one unit of foreign currency increases.

Other Factors Affecting Exchange Rates

1. Economic Strength: The rise in the value of foreign currencies is linked to the economic strength of the country issuing that currency.
2. Declining Exports: Lower export prices affect the amount of foreign currency inflows.
3. Crises and Disasters: Wars and natural disasters may cause exchange rate fluctuations.
4. External Debt Service: Increased debt servicing costs can negatively impact the value of the currency.
5. Interest Rates: Interest rates directly affect exchange rates; when interest rates drop, investments and demand for capital increase, whereas higher interest rates reduce demand for loans, slowing economic growth.

The Impact of Inflation on Goods Prices

Inflation means a continuous rise in goods and services prices, leading to a decrease in currency value over time. Inflation is usually expressed as the rate of price increases over a certain period, such as a year or month.
As inflation occurs, the relative prices of goods change, which affects how spending is distributed across various goods and services. Additionally, price increases for specific goods do not necessarily indicate inflation unless there is a general increase in prices.
Inflation also leads to a decrease in real wages (purchasing power of wages) in many cases, as prices rise while wages do not keep up with these increases, lowering the standard of living. On the other hand, some people, like property owners and stock investors, may benefit, while bondholders lose out because the fixed interest they receive loses its real value. Borrowers benefit from inflation due to the decreased future value of their debts.
Overall, inflation redistributes income and affects the value of real wealth, leading to a decline in the purchasing power of money.

Government Actions to Limit Inflation

Government policies can limit inflation by implementing a combination of monetary and fiscal policies, including:
First: Economic Policy
• Determining revenue sources and budget surplus through fiscal policies, reducing market liquidity.
• Selling public debt to decrease liquidity.
• Increasing taxes on luxury goods.
• Reducing government spending.

Second: Monetary Policy
Central banks implement monetary policies using quantitative and qualitative tools:
• Quantitative tools:
o Increasing the discount rate in commercial banks.
o Raising the sale of securities in open markets to reduce liquidity.
o Increasing the legal reserve ratio for commercial banks, reducing their lending capacity.
• Qualitative tools:
o Convincing commercial banks to reduce market liquidity through adopted policies.

The Impact of Inflation on Interest Rates

Interest rates are greatly influenced by inflation. When inflation rises, production costs increase, leading to a higher demand for capital to cover these costs. This increase in the demand for money leads to a rise in interest rates.

For example, if a company planned to allocate ten million for an investment in a project, the cost of loans may increase due to inflation. This makes borrowing more expensive, impacting investment decisions. Conversely, governments might raise interest rates to control inflation by reducing demand for loans.

Conclusion

Inflation is a complex economic phenomenon with diverse causes and significant consequences for various sectors. Governments and central banks use various monetary and fiscal measures to try to control inflation, balancing economic growth and stability.