Causes and consequences of inflation

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Definition of inflation

Inflation is the general increase in the prices of goods and services. Although most consumers see inflation as evil incarnate, inflation is sometimes beneficial. But before looking at the consequences of inflation, let’s first look at its causes.

Causes of inflation


Monetary inflation

: In this case inflation is due to an increase in the money supply (banknotes, coins, demand deposits, treasury bills, etc.) by the central bank (the FED for example) that issues banknotes. The reasons for this increase are explained in the article dedicated to monetary creation.The central bank is not solely responsible for monetary inflation, commercial banks also play a very important role in providing loans to the various economic agents (individuals and businesses).

This type of inflation is considered to be linked to poor management by the State, which often uses the "printing press" technique to reduce the amount of repayable public debt.


Inflation through costs or imported inflation

: In this case inflation is due to the increase in the price of imported raw materials, which is reflected in the sales price of the final product.Let's take the example of a tyre that is made from petroleum.If the price of oil goes up, then the tyre manufacturer will have higher manufacturing costs and will have to pass on this increase when selling its tyres.The company can certainly absorb some of the increase in raw material prices, but if the increase is too large, it is very difficult to maintain sales prices.


Demand inflation

: In this case inflation is due to an imbalance between the supply and demand of a certain product. Indeed, if demand is greater than supply, then prices will increase automatically until it reaches a break-even point. If supply is unable to meet demand, then product scarcity means that prices continue to rise which creates inflation.


Inflation by indexation

: In this case inflation is due to indexing the price of certain products to the prices of intermediate products used in their manufacture.Let's take our tyre example again to make it easier for you to understand.If the selling price of tyres increases, then the selling price of a new car is also likely to increase, since tyres are an integral part of the car's costs.


Inflation through a lack of confidence in the currency

: The money we use every day is only as valuable as the trust we place in it.In financial markets, lack of confidence in a currency leads to a fall in its exchange rate.If, for example, investors are suspicious of the euro for x reasons, then the euro will depreciate against other currencies.By losing its value, it will encourage inflation.The effect is, for example, an increase in euro prices for products imported from the United States.


Inflation through monetary policy

: Central bank’s reduction of key interest rates increases inflation automatically. On the one hand, the currency will depreciate because of the carry trade phenomenon (less lucrative currency) and on the other hand, commercial banks will borrow massively from the central bank (the cost of money being lower). In addition, the commercial banks themselves will lend more to economic players, which will create even more inflation.

Inflationary causes are therefore multiple and it is difficult to reduce inflation to a single factor.

The consequences of inflation


Wage increases

: In most developed countries, wages are indexed to price levels. So, if inflation is 3% then wages will also, theoretically, increase by 3%. There is therefore no loss of purchasing power.There is, however, room for criticism. Indeed, the calculation of the price index (on which wages are indexed) is often distorted. In the calculation of this index, more importance is placed on consumables which are considered necessities, than on other expenditure. For example, rent, which is one of the main household expenses, accounts for a small portion of this index. Conversely, changes in food prices play a major role. So there is a difference between real and perceived inflation.

If wages rise faster than prices, then households get richer.Conversely, if wages rise less quickly, then there is a loss of purchasing power.


Debt relief for debtors

: 1 euro today is not worth 1 euro tomorrow. When there is inflation, 1 euro tomorrow is worth less than 1 euro today.So, if you have a fixed-rate bank loan, the amount to be repaid each month will be the same, but this will represent a smaller share of your budget. This is one of the reasons the United States often resort to significant money creation. Inflation due to this creation reduces the burden of public debt that the State must repay to its creditors.

On the other hand, creditors, who are due to be reimbursed their receivables in a currency that hasless value than when the loan transaction was carried out, lose some of the debt’s value.

Similarly, households with variable-rate borrowings will be affected by a rate hike from the central bank if it decides to raise its key rates. The variable-rate borrower will then have a higher percentage of interest to repay than when the loan was granted.


Promotes exports

. Inflation promotes product export. Effectively, inflation causes the value of our currency to depreciate against other currencies and therefore it is cheaper for foreign importers to buy our products.Inflation therefore boosts our country's economic activity and ultimately creates new jobs to meet the additional demand.

Conversely, inflation is detrimental to importers who have to pay higher prices to import foreign products, because of the depreciation of their currency against foreign currencies. If a country is highly dependent on external energy, then inflation will increase its energy bill.


A sign of a country’s good economic health

: Inflation itself is not bad because it is a sign of economic growth. However, this inflation must be moderate and not exceed the GDP growth rate.A country’s real growth rate is calculated as follows: GDP growth rate - Inflation growth rate.

If inflation is higher than GDP growth, then the real economy is in recession.


Favours asset holders

: Inflation increases the value of your property. If there is a price increase, it is generalized throughout all goods and services and the value of your property will be higher.For other types of assets, the principle is the same.

Conversely, investors will pay more to acquire a property or asset.

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