Understanding inflation: definition, mechanisms, and economic impacts

What is inflation exactly?

Have your grandparents ever told you that a baguette used to cost a fraction of what it costs today? Welcome to the world of inflation. In simple terms, inflation definition can be summed up like this: it is the gradual loss of purchasing power of a currency over time. In other words, the same amount of money allows you to buy fewer things than before.

More technically, inflation is a sustained and generalized increase in the price level in an economy. It is not simply that the price of one product increases (it's just a relative price change), but rather that almost all goods and services gradually become more expensive. It is a phenomenon that extends over the long term, generally measured as an annual percentage change.

The Multiple Origins of Inflation

When money circulates too abundantly

Basically, inflation arises from two fundamental mechanisms. The first? An excessive amount of money in circulation compared to the goods available. Imagine the gold rush of the 15th century: when the conquistadors brought tons of gold and silver ingots from America to Europe, all of a sudden, there was much more gold in circulation. Result? Prices soared. This is inflation through excess money supply.

When supply does not meet demand

The second mechanism is more intuitive: a shortage of highly demanded products. When everyone wants to buy a good but there is not enough of it, prices rise. And this increase can spread to other sectors, creating widespread inflation.

The three main forms of inflation

Demand-pull inflation

This is the most common form. It occurs when consumers want to spend and buy more. Imagine a bakery that produces 1,000 loaves of bread per week and sells them all regularly. Suddenly, due to an economic improvement, people are earning more and want to buy more bread.

Problem: The bakery is already operating at maximum capacity. The ovens cannot produce any faster, and the workers are already working at their maximum. Building new equipment takes time. In the meantime, there are more customers than available loaves of bread. Naturally, some customers will agree to pay more to get some. The baker raises his price. Multiply this scenario across all economic sectors, and you have demand-pull inflation.

Cost-push inflation

Sometimes, it's different. Prices rise not because people are spending more, but because production costs more. Let's go back to our baker, now able to produce 4,000 loaves thanks to his new equipment. But here's the thing: the wheat harvest has been disastrous this year. There isn't enough grain for all the bakers in the region. As a result, wheat costs more. The baker has no choice but to raise his selling prices, even if his customers do not want to spend more.

Other factors can cause this inflation: an increase in the minimum wage, higher government taxes, or a weakening currency ( making imports more expensive ). This type of inflation is often caused by supply shocks – external events that make production more costly.

The embedded inflation: the self-sustaining cycle

It is the most insidious. Embedded inflation occurs when the effects of the two previous types settle permanently in the minds. Workers and businesses begin to expect inflation to persist.

Here’s how it works: after years of inflation, employees demand salary increases to maintain their purchasing power. Companies, seeing their costs rise, increase the prices of their products. Employees see the cost of living increase, so they demand even higher wages. Companies raise prices again. And the cycle continues, creating a self-sustaining inflationary spiral.

How do governments control inflation?

Increase interest rates: the main strategy

When inflation becomes threatening, central banks use their main weapon: raising interest rates. Higher rates make borrowing more expensive. A mortgage becomes less attractive, as does an auto loan. Personally, it becomes more appealing to save than to spend.

The result? People and businesses are buying less, demand is falling, and prices are no longer rising as quickly. It's effective, but the flip side: an economy that grows more slowly, as investments are also slowing down.

Act on fiscal policy

Another approach is to modify public spending and taxes. If a government raises income taxes, citizens have less money to spend. Aggregate demand decreases, and theoretically, inflation slows down. But beware: raising taxes is politically unpopular and can harmfully slow down the economy.

Quantitative easing and tightening

Central banks can also act directly on the money supply. Quantitative easing (QE) involves injecting money into the economy by purchasing assets. It's useful in the event of a recession, but it worsens inflation. The opposite – quantitative tightening – reduces the money supply, but its effectiveness against inflation remains debated.

How is inflation measured?

To know if inflation is a problem, it must be measured. This is done through indices, the most well-known of which is the consumer price index (CPI).

The CPI measures the prices of a wide range of goods and services that households regularly purchase: food, housing, transportation, etc. Government statistics ( such as the Bureau of Labor Statistics in the United States ) collect this data monthly from stores across the country.

Take a reference year with a score of 100. Two years later, the score rises to 110? This means that prices have increased by 10% over two years. Simple, but powerful.

The Two Faces of Inflation

Its advantages

Moderate inflation is not necessarily bad. It encourages spending and investment: why let your money sit idle if it will lose value? It's better to buy immediately. Companies, protected by anticipated inflation, can justify price increases and thus boost their profits. Moreover, slight inflation is infinitely preferable to deflation – where prices fall and consumers postpone their purchases, slowing down the economy and increasing unemployment.

Its dangers

But if it becomes uncontrollable, inflation ravages the economy. Your lifetime savings gradually disintegrate. Hyperinflation – when prices rise by more than 50% per month – is catastrophic. A product that cost 10 dollars costs 15 dollars a week later. Currency becomes useless. Historically, it is an economic and social disaster.

High inflation also creates uncertainty: businesses and individuals do not know what to expect, they save instead of investing, and economic growth stagnates.

Conclusion: the fragile balance

Inflation is an unavoidable reality of modern economies based on fiat currency. The challenge is not to eliminate it, but to control it. When it is managed – typically between 2 and 3% per year – it stimulates a healthy economy. It is when it runs wild that it becomes destructive.

Governments and central banks must continuously adjust their monetary and fiscal policies, navigating between two pitfalls: excessively high inflation that erodes wealth, and deflation that paralyzes growth. It is a delicate balance, but well understood, it is also a tool for economic stability.