Inflation 101

I could still remember during my grade school days, a bottle of soda would cost around two pesos; a jeepney ride around one peso; and a kilo of rice for just five pesos. Today, that bottle of soda costs around P10; that jeepney ride for seven pesos; and that kilo of decent (non-NFA) rice for P33.00.

Price increase is so deeply ingrained in our subconscious that we have accepted the fact that it always happen. And when that kilo of rice goes up to P100.00, we wouldn’t be surprise at all. This increase in the overall prices of commodities is called “inflation”.

CAUSES

Inflation might look very simple at first glance, but until today, it is still an enigma to economists as to what is the sure cause of it. There are a lot of schools of thought when it comes to the causes of inflation. Below are the two most subscribed opinions:

Supply and Demand point of view:

Cost-push inflation – in this scenario, inflation is caused by shocks in the factors of production (labor, land, capital goods, raw materials). A sudden increase in the price of gasoline would trigger a lot of price increase in other products because most of the finished goods need to be transported, and for a firm to generate profit, it has to factor in the cost of gasoline in determining the price of its goods.

Although this is not a type of supply shock, a good example for this is the annual salary increase of employees. Labor is one of the major factors of production (productive inputs) of a typical firm. If overall salary increases in a year, a firm has to make a decision whether to move the price of its goods and services upward too, and most of the time, it does move upward. This has a spiraling effect on the overall prices of goods and services.

Demand-pull inflation – this is the case wherein the demand of goods and services are greater than the goods and services available. When private citizens and the government spend too much money than what the available goods and services can offer, this puts a pressure on the general level of prices.

Theory of money supply and money demand:

Increased money circulating in the economy will lead to inflation. If private individuals have a lot of money to buy goods and services, suppliers, on the other hand will increase the price of their goods and services until such time that the overall level of prices has increased compared to its previous level. The private individuals will have to sustain a higher level of money in order to get the same desired quantity of goods and services, and the inflation spiral goes upward and upward.

Increased government spending will also lead to inflation, and in extreme cases, might lead to hyperinflation. If the government has to spend additional money than what it has on hand, it might resort to “seignorage”, or printing of money by the central bank. Since the government has more money than the time before it has printed money, it buys more goods and services. Suppliers will increase the prices of the goods and services, until such time the government needs to print more money to attain the same quantity of goods and services it desires to have. Governments depending too much on seignorage to fund their needs have been historically proven to cause hyperinflation resulting in their country’s economic meltdown.

In order to limit the inflation, the government buys back its money by issuing treasury bills, bonds, etc.

As a principle, the more money circulating in an economy, the higher the resulting inflation. The reason behind this is that the money circulating in the economy tends to cheapen the value of money because it is abundant. Therefore, prices of goods and services will increase because of this abundance until such time that the money circulating is just enough (not abundant) to buy the goods and services.

Once again, the money circulating won’t be enough to match the value of goods and services, people will have to increase money supply again to match the value of goods and services, and the inflation spiral goes upward and upward.

Behind all these principles, we always go back to the basics of economics. Why do salaries increase? Is it because employees need to protect themselves from the rising prices of commodities? Why do prices of goods and services increase? Is it because of the increase in the salaries of employees? That is why inflation is still a phenomenon to this date. There is always a “chicken or egg” debates as to which causes inflation.

Or is inflation a simple case of the effect of monocentricity of man? In economics, one of the basic assumptions about man is his monocentricity when it comes to his choices, meaning, every choice of man is made in order to satisfy his own needs, and such needs are intrinsically “insatiable”. This insatiability leads a man to need or want for more, thereby uses inflation as a means to achieve these needs and wants

MEASURING INFLATION

As a standard, inflation is either in a form of a percentage or index.

The most popular way of measuring inflation is through the Consumer Price Index (CPI), where the prices of basic commodities such as oil, food and services are put in one basket and compared on a yearly basis. For example, a CPI contains the prices of gasoline, fruits, vegetables, beef, pork, chicken for the year 2008, compute for the average price of all these commodities and in 2009 do the same. Divide the current year by the previous year, and you’ll get the one-year inflation rate.

Another way of measuring inflation is through the Gross Domestic Product (GDP) deflator. Nominal GDP is compared to a certain base year GDP in order to see the “real GDP” of an economy.

For most economists, the GDP deflator is the better measure of inflation, since the CPI depends on a basket, and normally the basket does not contain all the commodities of goods and services available in an economy, therefore it renders the index to be more biased than the GDP deflator.

IS INFLATION A GOOD THING OR A BAD THING?

There is no clear cut answer as to whether inflation is a good thing or not. Several debates by various schools of thought have been fought. But what is true is that inflation is not a problem as long as real wages or income of people also increase the same rate as it does. And as long as it does not lead to hyperinflation, then inflation is just an ordinary thing an economy has to get by. You can avoid inflation by not holding too much money or by placing them on investments that yield high returns enough to cover up the inflation portion.

Photo: “DSC_1601” by , c/o Flickr. Some Rights Reserved

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