Inflation explained

Inflation refers to the increase in the cost of living over time. Economists calculate inflation by determining the price of a typical basket of goods and services. An inflation rate of 10% means that prices have gone up by that amount. High inflation can have winners and losers, as the value of money decreases. Most countries aim for an inflation rate between 1 and 3%. If inflation gets out of control, it can lead to hyperinflation. Deflation, when prices fall, can also be problematic. The main cause of inflation is when the supply of money grows faster than the output in an economy. Supply shocks can also cause inflation. When economists speak about inflation, they usually mean price inflation, or the rate at which the cost of living in an economy goes up from year to year. The concept is simple, but how do you calculate inflation? Does inflation matter, and what causes it? To calculate the inflation rate, economists first determine the typical basket of goods and services an average person buys. These include people's spending on food, clothing, housing, and everything else they consume. They then calculate the price of this basket. For example, if in year one the basket cost $100, and in year two it cost $110, then the general price level in the economy has gone up by 10%. This is what we mean by the inflation rate, or the change in the consumer price index. When economists calculate this, it gets quite complicated since there are so many different items that we buy, and our basket of goods and services changes all the time. An inflation rate of 10% seems high, but if incomes rise at the same rate as the price level, then people in the country as a whole are not worse off. When inflation is high, there are winners and losers. Imagine you have a lot of cash, or you have a fixed income or pension. With high inflation, the value of your money will drop quickly. As prices rise, you will be able to buy fewer things with your money. On the other hand, if you have taken out a big loan, it will be easier to repay it if inflation is high, since the money you need to pay back has decreased in value over time. Today, most countries aim for an inflation rate somewhere between 1 and 3%. If inflation is very high, it can get out of control and turn into hyperinflation. In this case, prices rise at a faster and faster rate, and people lose confidence in the currency. This happened in Germany in the 1920s and in Venezuela in 2015. If prices fall, then there is negative inflation, also called deflation. Deflation can be a big problem for an economy, because people will postpone their purchases as they wait for prices to fall further. The main cause of inflation is when the supply of money grows faster than the real output in an economy. With more money chasing the same quantity of goods, prices will increase. However, there are circumstances when increasing the money supply does not cause inflation, for example when there is spare capacity or unemployment in an economy. Then the extra money can stimulate demand and grow the economy without causing inflation. Another cause of inflation is a supply shock. For example, when oil prices rose quickly in 1973, everything became more expensive, since so many products and services use oil as an input. That concludes the intro to inflation. Check our other videos for more insights. Brought to you by Sim Institute.