What is inflation?

Inflation is the increase in the general level of prices. In other words, too much money chasing too few goods. the same amount of money buys fewer goods than it could buy before.
The inflation rate is the average rate by which prices are rising. It is the rate of change of the price level from one year to the next, measured by the percentage change in an index of prices.
There are different price indices, depending on the bundle of goods and services included in the index.

The most commonly used measurements of inflation:

a.      The consumer price index – CPI:

     CPI measures the average cost of a standard basket of consumer goods and services. Each element in the basket is multiplied by its weight, and the weighted prices are added up to generate a single number called the consumer price index. the weight of each good and service in the index corresponds to its share in the budget of the average consumer.

b.      The producer price index – PPI:

The Producer Price Index (PPI) measures the average change over time in the prices of goods and services bought and sold by domestic producers. 

There are mainly three indices of producer prices, depending on the set of items included in each price index.  

The output PPI measures changes in the prices of products sold by businesses. However, Producers do not all sell the same set of goods and services. Thus, there can be more than one output PPI depending on the particular bundle of goods and services selected.

 The input PPI measures the prices of inputs of goods and services purchased by the producer. It is a measure for deflating the value of intermediate inputs used in production. Intermediate inputs of an industry are the goods and services (including energy, raw materials, semi-finished goods, and services) used in the production process to produce other goods or services.

The value-added PPI serves the purpose of deflating changes in value-added over time. It is a weighted average of the differences between output and intermediate input price indices.  

The producer price index measures price changes from the seller’s perspective, while the Consumer Price Index (CPI) measures price changes from the purchaser’s perspective. Sellers’ and purchasers’ prices may differ due to government subsidies, sales and excise taxes, and distribution costs.

c.       The GDP deflator:

It includes all of the goods and services produced in the country, weighted by their relative values as a fraction of GDP.
The GDP deflator measures the evolution of prices between two years. When the value of production increases over the course of a year, it is, therefore, important to know if this is due to an increase in quantity or volume of real production, or rather an increase in prices.

Types of inflation

There are different types of inflation depending on their rate of change, causes, consequences, the set of items that each price index contains, and their different weights.

To have a clear understanding of those different types, we classify them into three main categories: rate of change, volatility, and causes.

the rate of change

 The degrees of intensity by which inflation is rising or falling have different impacts on society and economic activity. Studying inflation behavior through its annual percentage change is widely indicative of its possible effects.

volatility:

 Price indices tend to differ in their volatility as some contain more volatile items than others. Each price index covers a different set of goods and services and gives more or less importance (weight) to one commodity or another in the averaging process. 

inflation causes:

 Classifying inflation by its causes helps to identify its main reasons and allows us to track and forecast possible price developments and whether those reasons are transitory or structural factors.  

Classified by the rate of change (momentum):

– Low inflation:

It is a slow increase in prices below normal or aimed average. It may look good, as it keeps goods and services prices at low levels and maintains the currency purchasing power.
However, very low inflation is usually accompanied by lower rates of growth. This situation is a negative signal for economic activity, as persistent lower demand may lead to deflation.

– Normal, acceptable level of inflation

It is the most favorable situation where the inflation rate runs close to the optimal average that maintains the balance between supply and demand, which favors economic growth and investing and leads to a steady rise in wages and lower unemployment rates.
An acceptable inflation rate is a rate that is neither too high nor too low. It prevents the economy from experiencing harmful deflation if the economy weakens.
In most developed countries, policymakers consider 2% as an acceptable inflation rate.

– High inflation

It is the increase in the inflation rate to reach higher levels above the normal average.
Countries like the United States experienced some periods of high inflation, like “the great inflation” period, which began in January 1965 and ended in December 1982.
In the 1970s, prices increased rapidly from 2% on average in the early 1960s to 12% in December 1974.
After two years of a downward correction in prices between 1975 and 1976. inflation began to rise again by early 1977 to reach its peak in March 1980 at close to 15 percent.
Even though 15% is not considered hyperinflation, it is still relatively high and damages business and financial activity.
High inflation eats both debt and savings. It benefits debtors as they borrow more and pay less in value and hurts creditors as the real returns diminish.

Consumer Price Index for All Urban Consumers: All Items in U.S. City Average

– Hyperinflation:

It is inflation of higher magnitude, which has a severe impact on people and the economy. 

At the end of the First World War, Prices in Germany in 1923 increased at a rate of 230% per month, which means that everyday commodities were 6% higher than the day before; workers were forced to spend their pay the same day that is was received before the money became worthless. Inflation of this magnitude is called hyperinflation.

Periods of hyperinflation occur only occasionally. In modern economic history, examples of countries that have experienced hyperinflationary episodes include Israel, where prices increased 400% in 1985. Argentina, where they went up by 700%. And Bolivia, where the annual price increase in 1984 was a staggering 12,500%.

Venezuela is a recent country experiencing hyperinflation due to currency instability as well as political and socio-economic problems. By the end of 2018, the annual inflation rate reached 1,698,488%; prices were increasing at a daily rate of 3%.

The main cause of hyperinflation in Venezuela lies in the monetization of the fiscal deficit through huge quantities of money supply by the Central Bank of Venezuela. And the lack of foreign exchange due to the fall in the country’s oil production.

Deflation:

It is a persistent decline in the prices of goods and services. Consumers may delay purchases if they expect prices to fall. As a result, falling prices can lead to lower spending. Businesses could respond by laying off workers or reducing wages, which, in turn, places further downward pressure on demand and prices and causes a recession.
During deflationary times, inflation rates are usually negative.

Disinflation :

Disinflation refers to a deceleration in price momentum. Inflation rates move from increasing at higher levels into increasing at lower levels.
For example, where the inflation rate declines from 8% to 3% on a year-over-year basis, prices are still rising but at lower rates.
In the case of disinflation, rates are still positive and do not move to the negative territory. This situation is desirable for the economy after experiencing moments of high inflation. the rate of increase in the general level of prices slows down, which reduces the harmful impact of high inflation and leaves the minimum rate of increase necessary for economic growth and activity.

Reflation:

It is a term used to describe inflation that comes during recovery times.
During recessions, we often experience a decline in booth growth and inflation. During the recovery part of the business cycle, some pickup in prices may happen because of a rise in demand. We call this reflation as it turns from a negative to a positive rate of increase.

Stagflation:   

It is a combination of two words “stagnation” and “inflation”. It occurs when the country experiences a decline or stagnation in growth at low levels, whereas inflation is too high. Periods with Higher inflation and lower growth are known as stagflationary.

Classified by volatility:

Core inflation

Core inflation measures the change in average consumer prices after excluding certain volatile items. It is a common measure of the underlying price movement.
Core inflation is often used as an indicator of the long‐term inflation trend as well as future prices. The long‐term trend is primarily affected by demand conditions which, in turn, can be influenced by monetary policy.
Since the prices of energy and food items tend to fluctuate and create ‘noise’ in inflation computation, core inflation is less volatile than headline inflation.

How is core inflation measured or computed ? 

The standard way used to compute core inflation is through excluding a pre‐defined set of items from the headline price index.
The excluded components are considered volatile items and typically consist of food and energy items. This is based on the idea that the markets related to these goods are subject to supply shocks.
Meanwhile, other computation methods can be used to strip out volatility from the headline index, such as the trimmed mean and weighted median measures.
In the United States, excluded components from the CPI basket are mainly food and energy items. They represent about 21% of the total index. Food and beverages represent about 15%, and energy counts for about 6%.

Why do we need to measure core inflation ? 

Headline inflation is often influenced by volatile factors (food and energy prices), which may cause inflation to temporarily move away from its long‐term trend.
Sharp price changes of individual goods caused by supply or demand shocks may drive headline inflation to reach high levels, even though the prices of other CPI components show only mild increases.
Bad weather can drive up food prices. Disturbances in the oil supply can push energy prices very high. Since these supply shocks are temporary, they should not have any lasting effect on the general price level.
Measuring core inflation helps policymakers determine whether current movements in consumer prices represent transitory disturbances or are part of a more permanent trend. Such knowledge is critical in the formulation of economic and monetary policy to counter broad‐based price pressures.

Headline inflation

Headline inflation refers to the rate of change in the CPI, a measure of the average price of a standard basket of goods and services consumed by a typical family.
Headline inflation thus captures the changes in the cost of living based on the movements of the prices of items in the basket of commodities and services consumed by the typical household.

When Should Headline Inflation Be Used?

Headline inflation is a standard measure for comparing purchasing power development over time. Comparisons over time of wages, wealth, real rates of return, and government transfers such as Social Security payments should all use a headline measure of inflation because all of these concepts depend on a broad measure of inflation.
In addition, some inflation-adjusted government programs and taxes rely on headline inflation. Real GDP growth is also calculated by first adjusting nominal output by headline inflation.
For example, adjusting household income by core inflation would not be useful since food and energy consumption account for about 25% of average household expenditures.


Movements in headline inflation are a combination of movements in the underlying trend inflation rate as well as transitory price movements. The various measures of core inflation (less food and energy, weighted median, trimmed mean) represent various approaches to stripping out the transitory movements in prices.

Classified by inflation causes:

Demand-pull inflation:

a shift in the demand curve affects prices
a shift in the demand curve affects prices

It counts for inflation caused by a rise in demand. As demand increases, a rightward shift in the demand curve drives prices higher.
Among the reasons behind the rise in demand are positive consumer and business sentiment and the rise in households’ income and firms’ profit margins.
Moreover, an expansionary fiscal policy stimulates demand through government spending and lower taxes on firms and households.

Cost-push inflation:

 a shift in the supply curve affects prices
a shift in the supply curve affects prices

It is a rise in inflation because of a higher cost of production and supply shortages. Consequently, a decrease in supply leads to higher prices.

The following elements are Key Factors Responsible for Supply Shortages and higher production costs.

         a- Structural, bottle-neck inflation:

Lack of skilled labor, shortages in some commodities or raw materials, and supply chain disruptions drive supply to fall drastically while demand remains at the same level. As demand continues to outpace supply, prices continue to increase.

    b- Hoarding and speculation:

It is the case where speculators purchase and hold large amounts of inventory of a commodity to benefit from future price increases due to possible supply shortages of that commodity.

    c- Taxation:

Higher taxes on production and imports of goods and raw materials are additional factors causing cost-push inflation.

Increase in money supply: 

A higher money supply increases the availability of cheap money in the market, which may push many firms to expand their businesses, and hence a positive impact on economic growth.
In theory, according to the quantitative theory of money, there is a relationship between money supply and prices. It implies that prices are proportional to the money supply. Any increase in the money supply causes an increase in prices.
This theory holds for developing countries more than developed ones.