Inflation is an economic indicator that measures the rate of change in the prices of goods and services in the economy over time. It reflects the decline in the purchasing power of the currency. The inflation rate is measured as a percentage that indicates an increase in prices.
Measuring inflation is a core economic aspect, as it reflects the cost of living and the value of the national currency. The increasing purchase power reflects the currency’s strength, while a declining purchasing power indicates the currency’s weakness.
Inflation in general is a broad gauge that can point to the average price changes and cost of living. It can also be narrowed to calculate the change in the price of certain goods and services. It is measured by the Consumer Price Index, also known as CPI.
What are the Main Drivers of Inflation?
- Monetary Policy: Through monetary policy, central banks control the supply of currency in the market. Excess supply of money leads to higher prices and declining value of the currency.
- Fiscal Policy: It guides the borrowing and spending levels of the economy. Higher borrowings, debt, result in increased taxes and additional currency printing to repay the debt which weakens the currency through higher supply, causing prices to rise.
- Increasing Demand: The gap between the higher demand and lower supply is a major cause of inflation.
- Higher Costs: Rising prices of goods and services due to increased cost of production, generates inflationary pressures.
- Interest Rates: Changes in the interest rates have a direct impact on inflation. Higher rates combat inflationary pressures in prices, while lower rates support prices to rise.
Effects of Inflation
The rising inflation rate can cause more than declining the purchasing power of currencies. It can also lead to faster economic growth as it can be a sign of rising demand. It can lead to an increase in costs due to workers’ demand to increase wages to keep up with the inflationary pressures. This might increase unemployment as companies will have to lay off workers to keep up with the costs.
Inflation causes the national currency to decline, which can benefit exporters by making their goods more affordable for foreign demand. On the other hand, higher prices negatively affect importers as foreign-made goods become more expensive. Higher inflation promotes spending, as consumers rush to purchase goods quickly before their prices rise further. While it can erode the real value of savings, limiting the ability of savers to spend or invest in the future.
How to Calculate Inflation Rate?
Inflation is measured by the Consumer Price Index (CPI). It can be calculated for any product by following these steps:
- Determine the price of the product at an earlier period, and the current price of the product.
- Use the formula: Final CPI/ Initial CPI x100 = Inflation Rate.
- This shows the increase/decrease percentage in the price of the product. This formula can be used to compare the inflation rate over a period of time.
The Three Types of Inflation
There are three common types of inflation; Demand-Pull, Cost-Push, and Built-in.
- Demand-Pull Inflation: It is a result of increasing demand for goods and services surpassing the production capacity, due to the increase of money and credit supply in the economy. The gap between high demand and low supply creates inflationary pressures on the prices.
- Cost-Push Inflation: It is driven by higher production costs, like a rise in the price of raw materials. This may lead to a decrease in the aggregate supply of goods and services and results in higher consumer prices.
- Built-in Inflation: Expectations of future price pressures create built-in inflation through rising wages to afford the higher cost of living. This results in higher cost of production, causing prices to eventually rise.
Opposite to inflation, deflation is the steady decrease in the prices of goods and services. During deflation, the purchasing power of the currency increases. That means you can buy more goods or services tomorrow with the same amount of money you have today. Deflation usually accompanies weaker growth and is a sign of economic recession.
Deflation should not be confused with disinflation which signifies that prices are still rising, just at a slower pace. That could be a change from 3% annual inflation to 1% annual inflation.
Stagflation happens when inflationary pressures accumulate despite the stagnant economic growth and high unemployment rate. Stagflation is abnormal because a weak economy does not generate inflationary pressures. It defies the inverse correlation between unemployment and inflation described by the Phillips curve. So, it is a challenging economic situation for policymakers as the tools used to combat inflation typically drive higher unemployment.
Hyperinflation is a very rare economic phenomenon that happens when prices soar by more than 50% during one single month. Hyperinflation crashes the value of the currency and reflects the economic crisis. Venezuela’s hyperinflation is one of the most recent examples in modern history. The inflation rate in Venezuela peaked at nearly 350,000% in 2019 and the Venezuelan Bolivar lost 6 zeros to the US Dollar, making $1 equal to more than 4 million Bolivars. Venezuela is now experiencing one of the most severe episodes of hyperinflation in history, according to economists.
Learn more about fundamental analysis
To learn fundamental analysis is highly effective for investors and forex traders. The main outcome of fundamental analysis is to determine the key factors which affect currency prices. With the news release and economic events the market response and if the future economic outlook is showing recovery or improvement, the currency should strengthen. As a trader is highly beneficial to master the basics of fundamental analysis and apply it in your trading strategies.
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