What is inflation? This is how it affects us

Definition and Example

Inflation is an increase in the general level of prices within an economy. This can be identified by a rise in the price of many items, not just one specific product.

In the current situation, the value of an economy’s currency decreases, resulting in fewer items being able to be purchased with the same amount of money.

A current example is the Russia-Ukraine war which has had a significant impact on the availability of various commodities. This shortage of items, in turn, caused prices for these items to increase–including new cars and houses. As manufacturers sought to capitalize on this trend by raising prices, consumers now face increased costs across the board.

Modern economists say that inflation occurs as a result of the creation of extra purchasing power for consumers over the same level of production. This means that extra money is generated in an economy without an increase in the level of production.

Where does the money come from?

However, this extra money needs to come from somewhere. This extra money comes from the government via public borrowing i.e. by issuing bonds to the public, government policies such as increasing minimum wages, printing currency, etc.

When governments raise money through public borrowings they spend it on developmental projects such as infrastructure and as a result, jobs are generated and people get paid the cash the overall public increases but there is no increase in the production of goods and services. So for the same set of commodities, the number of potential buyers will increase as a result demand will increase, and supply, on the other hand, remains constant due to which the overall price of commodities increase. This increase is inflation.

There are various metrics used for the measurement of inflation such as Consumer Price Index Inflation (CPI), and Wholesale Price Index Inflation (WPI).

Consumer price index

CPI is a measure of price changes in a basket of goods and services that mirror Consumer Expenditure in an economy. This means it provides the true picture of inflation, which includes items purchased by the public from wholesalers as well as those who bought at retail.

Wholesale price index

WPI, on the other hand, only tracks wholesale prices – not what consumers are paying for these items.

The government controls inflation by various means such as monetary policy, interest rates, etc.

Monetary policy

Monetary policy refers to the actions of the Federal Reserve Bank, which is America’s central bank. This entity oversees money, credit, and interest rates to achieve long-term economic goals. For more information about Monetary policy click here.

Interest rates

To understand interest rates it’s important to understand Federal funds rates.

Federal Fund rates are interest rates that banks charge when lending money to each other. This so-called fund rate is the interest that banks charge for borrowing from the Federal Reserve Bank (FED) in the USA.

Why do banks need to borrow money?

Banks borrow money to meet the needs of their customers when they have increased demand for loans and withdrawals as compared to deposits. When this occurs, banks turn to the FED for short-term borrowing assistance.

What happens when fund rates hike?

When the FED hikes its rate, banks are required to pay higher rates of interest on their borrowings. As a result, the cost of funds for banks increases.

Higher interest rates mean you will pay the bank more money to finance your goods. Therefore, as loans start to get expensive, people begin postponing their purchases. In effect, the demand starts to slow down, which, in turn, will slow down the price rise.

In effect, businesses and consumers tend to spend less when credits are expensive. It does slightly impact economic growth but also slows down inflation.