Inflation

Details
Last Updated: Monday, 03 February 2025 02:20
Published: Tuesday, 30 August 2022 21:50
Hits: 437

Inflation:

Inflation is the other major component of economy, the first one being GDP that we discussed in the other section. It refers to the price of everyday items going up on a yearly basis. If Apples cost $1/kg this year, and next year the same apples cost $1.10/kg, then inflation is 10% (as prices went up by 10%). Inflation is hard to measure as the same item may have changed or improved when compared from one year to other, so just using price differential as infltion gauge may not be fair. Also, the price of items may flutuate from store to store on a daily basis based on sales, coupons, etc. Some items may even disappear since sales may decline for that particular item due to change in customer's taste.

At it's core, inflation is devaluation of local currency. We measure inflation in terms of local currency. If you are able to buy fewer items this year than last year with a fixed amount of money, then your currency has devalued that much. Al the governments of the world want moderate inflation. They print new money every year, resulting in automatic devaluation of their currency.

 

Causes of Inflation:

Inflation may happen due to 2 reasons

  1. Money supply: More the money supply in the system, more will be the money (in local currency) chasing those goods. As an example, let's say there were $100 in the system, and there were 10 apples that were selling. Then each apple would sell for $10. However, if the money supply went to $150 due to the more printing of money, then now there's $150 available to buy those 10 apples. So, each apple will sell for $15, resulting in 50% inflation.
  2. Supply and demand: Lower the supply and higher the demand, more will be the price of that particular item. Conversely, higher the supply and lower the demand, lower will be the price. This supply and demand may apply to different items differntly, raising prices for some items, while lowering prices for other items. However, in aggregate, total price of all the items in the economy will still be bound by the amount of money in the system. As an ex, if prices of apple go up due to high demand/low supply, while price of oranges go down due to low demand/high supply, the total price of apple + oranges cannot exceed the amount of money in the system. If there's $100 in the system, and there were 5 apples and 5 oranges selling for $10 each, then if apples go up by 10% in price, then oranges have to come down by ~10%, as combined price of apples + oranges can't exceed $100 (i.e apples may cost $12 each, while oranges may cost $8 each).
  3. Growth (i.e GDP): This is another reason cited by most developing countries of the world as the cause for inflation. It says that an inevitable by product of strong growth is high inflation. This circles back to bullet 2 about demand/supply. With strong growth comes high demand. However supply should also get higher as there's growth in producing these items too. In a nutshell, correlation b/w growth and inflation is tenuous at best. Inflation is almost always due to Money supply. 
    • In an interview with CNBC’s “Street Signs Asia” on 29th Aug, 2022, Steve Hanke, a professor of applied economics at Johns Hopkins University, said that throughout world history, there had never been sustained inflation—inflation above 4% for more than two years—that had not been caused by excessive growth in the supply of money. He was referring to M2 money supply, the most accepted indicator of money supply in the economy.

 

Inflation in USA:

 

Now we'll look at inflation in USA and how it's measured.

Here's a link that shows the price rise of various items from 1925 to 2025, a span of 100 years => https://money.usnews.com/money/personal-finance/saving-and-budgeting/articles/how-much-household-staples-cost-in-1925-vs-2025