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Inflation

Inflation is the general rise in prices. While most consumers see inflation as the incarnation of the evil, inflation is sometimes beneficial. But before we examine consequences of inflation, we will the study its causes

Causes of inflation

Monetary Inflation: Inflation is then due to the increase in money supply (banknotes, coins, overnight deposits, treasury bills …) by the central bank which issues banknotes. The reasons of this creation are explained in the sheet dedicated to the money creation. The central bank is not solely responsible for monetary inflation, commercial banks have also a very important part due to funds they lend to various economic agents (individuals, enterprises).

We consider that this type of inflation is related to the mismanagement of the state which often uses this technique of “printing money” to reduce the amount of public debt to repay.

The inflation by costs or imported inflation: Inflation is then due to the rising price of imported raw materials which are reflected in the selling price of the final product. Take the example of a tire that is manufactured from oil. If the price of oil rises, so the company who create tires will get higher manufacturing costs and therefore must increase the selling price of its tires. The company can certainly absorb a part of higher commodity prices but if the increase is too large, it is very difficult to maintain its selling price.

The inflation by the demand: Inflation is then due to an imbalance between supply and demand of a certain product. Indeed, if demand exceeds supply, then prices will increase to find equilibrium. If the supply is unable to meet demand, then the scarcity of the product lead to an increase in prices and that will create inflation.

The inflation by the indexation: Inflation is then due to the indexation of prices of some products at the prices of intermediate products needed for its manufacture. Return to our example of tires to ease your understanding. If the sale price of the tire increases, while the selling price of a new car is likely to increase as well. In fact, tires are needed to make a car.

Inflation by the lack of confidence in the currency: The currency that we use every day gets its value by the trust we put into it. In financial markets, lack of confidence in a currency results in the fall of its exchange rate. If such investors are wary of the euro for some reason, then the euro will depreciate against other currencies. In losing its value, it will encourage inflation. In, fact, it will cost for example more expensive in Euros to import goods from the United States.

Inflation by the Monetary Policy: The rate cut by the central bank increases inflation mechanically. Indeed, on one hand the currency will depreciate because of the phenomenon of the carry trade (currency less profitable) and on the other hand, commercial banks will borrow heavily from the central bank (the cost of money is less high). In addition, commercial banks will lend itself more to economic actors and that will create even more inflation

The causes of inflation are numerous and it is difficult to reduce inflation to a single factor.

Consequences of inflation

Higher wages: In most developed countries, wages are indexed to the price level. So if inflation is 3%, then wages will also increase by 3% in theory. There is therefore no loss of purchasing power. However, we can make a critic about it. Indeed, calculating the consumer price index (which are indexed to wages) is often distorted. In the calculation of this index, consumer goods have much more importance than other expenses that can be done. Rents represent such a small part in this index when it is one of the main household budgets. Conversely, changes in food prices played one of the strongest role. There is a difference between real inflation and perceived inflation.

If wages rise faster than prices, so households get richer. Conversely, if wages rise more slowly, then there is a loss of purchasing power.

Debt reduction for debtors: 1 euro today not worth a euro of tomorrow. In case of inflation, 1 euro of tomorrow will worth less than the euro of today. So if you have a fixed rate bank loan, the amount to repay each month will be the same but it will represent a smaller share in your budget. This is one of the reasons that led the U.S to monetary creation. Inflation due to this creation reduces the weight of public debt that the state must repay to its creditors.

Conversely, there is loss of the value of debt for creditors that will be reimbursed with a currency that will be less valuable than the time on which the loan has been granted.

Similarly, households who have subscribed to a variable rate loan will themselves be affected by an increase of interest rate by the central bank. The borrower with a variable rate will then have a higher percentage of interest to repay compare to the movement on which the loan was granted.

Promotes exports: Inflation promotes the export of our products. Indeed, inflation do that the value of our currency depreciates against other currencies and therefore it is cheaper for foreign importers to buy our products. Inflation thus boosts economic activity in our country and eventually creates new jobs to meet the additional demand.

Conversely, inflation is bad for importers who pay more expensive to import foreign products due to the depreciation of the currency against foreign currencies. If a country have a strong energy dependence to the outside, inflation will cause it the increase of its energy bill.

A sign of economic health for a country: inflation is not bad because it is a sign of economic growth. However, this inflation should be moderate and not exceed the rate of GDP growth. The real growth rate of a country is calculated as follows: GDP growth rate – Growth rate of inflation

If inflation is higher than the growth rate of GDP, then the real economy is in recession.

Promotes asset holders: Inflation increases the value of your property. Indeed, if prices rise, this rise will be generalize to all goods and services and the value of your property will be more important. For other types of assets, the principle is the same.

Conversely, investors will pay more expensive to acquire a property or an asset.

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