Understanding inflation: beyond the simple definition

Have you noticed that groceries cost more each year? Your grandmother constantly repeats it to you: “In my time, it was much cheaper.” She is right. This phenomenon has a name: inflation. But far from being just a random price increase, inflation is a complex economic mechanism with specific causes, measurable consequences, and tangible solutions.

What is inflation really?

Beyond a simple definition, inflation represents the decrease in the purchasing power of a given currency. It is not a temporary fluctuation in the prices of one or two products, but a lasting and widespread increase in the cost of almost all goods and services in an economy.

The distinction is crucial: when we talk about “relative price changes”, we refer to isolated changes. Inflation, on the other hand, is a systemic and prolonged phenomenon. Governments measure it annually as a percentage, allowing for comparisons between periods. A consumer price index (CPI) showing a rise from 100 to 110 over two years means that prices have generally increased by 10%.

Where does inflation come from? The three main mechanisms

Demand-pull inflation: too many buyers, not enough products

Imagine a bakery producing 1,000 loaves of bread per week and selling out. Business is running smoothly. Suddenly, the economic situation improves: consumers earn more, they spend more. The demand for bread skyrockets. The baker cannot physically produce more – his ovens and staff are already operating at full capacity.

What's happening? Customers are crowding at the door. Some are willing to pay more to get their bread. The baker is raising his prices. This is demand-pull inflation: when people buy more than what is available, prices go up. On a larger scale, this is the type of inflation that occurred during periods of intense consumption.

Cost-push inflation: when production becomes more expensive

Our baker has finally built new ovens and hired staff. He is now producing 4,000 loaves of bread per week. The supply meets the demand. But here it is: a bad wheat harvest is hitting the region. The stock is running out. Our baker has to pay much more to find wheat.

Even if no one is asking for more, he raises his prices to compensate for his additional expenses. This is cost-push inflation. It can also be triggered by an increase in the minimum wage, a rise in government taxes, or a depreciation of the exchange rate making imports more expensive. Shortages of essential resources – oil, metals, cereals – are often at the heart of this mechanism.

The embedded inflation: the habit trap

If inflation persists for several years, a third phenomenon emerges: embedded inflation. It arises from prior economic activity and creates a cycle that is difficult to break.

How? Through inflation expectations. If inflation has reigned for years, employees expect it to continue. They negotiate salary increases to protect their purchasing power. Employers, seeing their costs rise, pass on the costs by increasing prices. Employees, noticing that everything is more expensive, demand even higher wage increases. This is the wage-price spiral: a self-reinforcing cycle where everyone tries to protect themselves and ends up fueling the problem.

How to measure inflation?

To combat inflation, it is first necessary to measure it. Most countries use a consumer price index (CPI), a tool that tracks the prices of a wide variety of goods and services purchased by households.

The CPI functions as a weighted average: a representative basket of goods is selected – food, housing, transportation, leisure – and we observe how their prices evolve. Organizations like the Bureau of Labor Statistics in the United States regularly collect this data from retailers to ensure the accuracy of the calculations. By comparing the indices from one period to another, we obtain a precise and reliable inflation rate.

Solutions to Control Inflation

Uncontrolled inflation can ravage an economy. That is why governments and central banks have tools to curb it.

Increase interest rates

The most direct strategy: central banks raise interest rates. Borrowing becomes expensive. Consumers hesitate to take out a loan to buy a house or a car. Companies think twice before investing. Demand decreases, prices stabilize. In return, saving becomes attractive – you earn more interest. But beware: too aggressive monetary tightening could stifle economic growth.

Adjust the budget policy

Governments can also raise income taxes. Households have less money to spend, demand decreases, inflation eases. But this approach is politically sensitive: taxpayers generally do not like to pay more. That is why central banks prefer monetary policy instead.

Control the money supply

Central banks can reduce the amount of money in circulation through quantitative tightening (QT), the opposite of quantitative easing. However, evidence of its effectiveness remains limited. Reality shows that adjusting interest rates remains the main remedy against inflation.

The Two Sides of Inflation: Advantages and Disadvantages

Why a little inflation isn't so bad

Moderate inflation is actually beneficial. It encourages consumers to spend and borrow now rather than wait – after all, their money will be worth less tomorrow. For businesses, it allows them to justify price increases and improve their margins.

Low inflation is also better than deflation – the decrease in prices. During deflation, consumers postpone their purchases, hoping to find better prices. Demand collapses, unemployment rises, and growth stagnates. Historically, deflationary periods have always led to major economic difficulties.

The dangers of uncontrolled inflation

But excessive inflation is destructive. If you keep 100,000 euros in cash under your mattress, that amount will not have the same purchasing power ten years later. Your wealth erodes silently.

Worse still: hyperinflation. It occurs when prices rise by more than 50% in a month. An item that costs 10 euros one week may cost 15 the next. The economy becomes paralyzed, people lose confidence in the currency, and transactions become chaotic.

Uncertainty also accompanies high inflation. Individuals and businesses become cautious, investment declines, and growth slows down. Furthermore, some criticize the tendency of governments to “create money” to combat inflation, deeming it contrary to the principles of a free market.

Conclusion: finding balance

Inflation is inevitable in modern economies based on fiat currency. It is only bad if it gets out of control. The art lies in balance: maintaining moderate inflation while avoiding an inflationary spiral or deflation.

To achieve this, governments must wisely and prudently combine fiscal and monetary policies. Raising interest rates, adjusting taxes, controlling the money supply – each tool must be wielded with discernment. Well-managed inflation is no longer a threat, but a natural mechanism of a dynamic and growing economy.