Understanding inflation: why your money is worth less each year

What is the definition of inflation exactly?

Most of us have heard that everything was cheaper in the past. This economic reality has a name: inflation. In simple terms, it is the gradual decline in the purchasing power of a given currency. Specifically, if 100 euros allowed you to buy 20 products five years ago, today you will only be able to buy 15 with the same amount.

A more comprehensive definition of inflation: it is the sustained and generalized increase in prices of goods and services in an economy. Unlike a simple price variation ( where only one item becomes more expensive ), inflation affects almost all sectors simultaneously. It is a persistent phenomenon, not a one-time event.

Most countries measure inflation annually, expressed as a percentage. This metric guides the decisions of governments, central banks, and investors – including those operating in cryptocurrency markets.

Where does inflation come from? The three main mechanisms

Demand-pull inflation

Imagine a thriving bakery producing 1,000 loaves of bread per week. Suddenly, the economic situation improves: people have more money to spend, and the demand for bread skyrockets. But the ovens are already operating at full capacity. It's impossible to produce more immediately.

Result? Some customers are willing to pay more for their bread. The baker raises his prices. If this dynamic spreads to several sectors – milk, oil, grains – you are witnessing demand-pull inflation: too much money chasing too few goods.

Historically, there are glaring examples. When European conquistadors massively brought gold and silver from America in the 15th century, Europe experienced brutal inflation. The money supply exploded, without a proportional increase in goods and services.

Cost-push inflation

Let's return to our baker, who has now built new ovens and hired staff. He produces 4,000 loaves of bread per week – the supply meets the demand.

One morning, disaster: the wheat harvest has failed. Grain is becoming scarce and expensive. Our baker has to spend more to stock up. He has no choice but to raise his selling prices, even though customers are not asking for more bread.

This cost-push inflation occurs also when:

• Governments are raising minimum wages
• Taxes on products are rising
• Exchange rates are deteriorating ( imports are becoming more expensive)
• Natural resources are becoming scarce

Integrated inflation: the infernal cycle

Embedded inflation is more insidious. It arises when inflation persists for a long time: employees demand higher wages to protect their real incomes, which drives companies to raise their prices, which in turn leads employees to demand even higher wages.

This is the famous price-wage spiral. Once set in motion, it becomes difficult to stop. Inflationary expectations – the idea that inflation will continue – manifest through economic behaviors that actually create more inflation.

How Governments and Central Banks Fight Inflation

Increase interest rates

It is the preferred tool of central banks ( such as the U.S. Federal Reserve ). Higher rates make borrowing more expensive. Businesses hesitate to invest, consumers to buy on credit. Demand decreases, slowing the rise in prices.

But be careful: excessively high rates also slow down economic growth. Businesses and individuals become cautious, reducing investments and spending.

Modify the budget policy

Governments can also increase income taxes. With less money available, households consume less, reducing demand. Theoretically, inflation decreases.

But it is an unpopular strategy: the public rarely reacts well to tax increases.

Control the money supply

Central banks can inject or withdraw money from the economy. Quantitative easing (QE) injects liquidity – which worsens inflation. Quantitative tightening (QT) withdraws it, but with little concrete evidence of effectiveness against inflation.

Measuring Inflation: The Price Index

Before taking action, one must measure. The standard tool is the consumer price index (CPI).

The CPI monitors the prices of a wide variety of goods and services purchased by households – a standardized consumption basket. Agencies like the American Bureau of Labor Statistics collect this data nationwide to ensure accuracy.

Take a base year with an index of 100. Two years later, it reaches 110. Conclusion: prices have increased by 10% over two years. Simple and effective.

A slight inflation (2-3% annually) is even beneficial – it encourages spending and borrowing. But without oversight, it quickly goes off track.

The Benefits of Moderate Inflation

Yes, inflation has advantages:

Incentive to consume and invest: If you know your money will lose purchasing power, you are tempted to buy now rather than save. This stimulates the economy.

Increase in Profits: Companies justify price increases by inflation, but they can raise margins beyond what is necessary – extra profits.

Preferable to deflation: The opposite of inflation – falling prices – seems positive. But it's not. If prices fall, consumers delay their purchases (" it will be cheaper tomorrow"). Demand collapses, unemployment rises, growth stagnates.

Historically, deflationary periods have coincided with recessions and massive unemployment.

The dangers: when inflation becomes destructive

Hyperinflation and monetary collapse

Uncontrolled inflation ravages economies and wallets. Hyperinflation – an increase of over 50% per month – is catastrophic. A good that costs 10 euros one week costs 15 the next. Prices quickly exceed 50%, 100%, or even more.

The currency itself becomes useless. People are reluctant to hold it. That is why some turn to cryptocurrencies as an alternative store of value – a hedge against monetary inflation.

Economic uncertainty

High inflation creates uncertainty. No one knows where the economy is headed. Individuals and businesses freeze, saving rather than investing. Growth slows down, innovation decreases.

Debate on State Interventionism

Some criticize government intervention to control inflation. They argue that the ability of governments to “create money” violates natural economic principles and the laws of the free market. This debate resonates particularly within cryptocurrency communities, where monetary inflation is at the heart of concerns.

Conclusion: Inflation, an Inevitable Reality of Modern Economies

Inflation is inevitable in today's fiat currency systems. Prices are rising, the cost of living is increasing – we accept it.

But controlled, inflation stimulates the economy. The best tools? Flexible fiscal and monetary policies that allow governments to adjust their response to the situation. Unfortunately, these policies require great caution: if applied poorly, they cause more damage than they repair.

For investors and asset holders, understanding the definition of inflation and its mechanisms remains essential to protect and enhance their wealth in a perpetually changing economic environment.