How to understand inflation and its impacts on your purchasing power

Introduction: Why Your Money is Worth Less Than Before

Are you wondering why the cost of living is constantly increasing? Why do products that cost a few euros a few years ago now seem much more expensive? The answer is called inflation.

Inflation represents the gradual reduction of a currency's purchasing power. In simple terms, it is a sustained and widespread increase in the prices of goods and services in an economy. This rise is not temporary – it is long-lasting. Most countries measure their inflation rates annually, expressed as a percentage.

Although some effects may seem positive in the short term, uncontrolled inflation creates uncertainty and erodes citizens' wealth. Hence the importance for governments to implement policies aimed at keeping inflation at a controlled level.

The three main mechanisms behind inflation

The demand that exceeds the supply

The first type of inflation – demand-pull inflation – occurs when consumers buy more goods and services than what is available. Imagine a baker capable of producing 1,000 loaves of bread per week. If, suddenly, economic conditions improve and consumers have more money to spend, the demand for bread explodes. As long as the baker is operating at full capacity, he cannot immediately increase his production. Faced with this relative shortage, some customers are willing to pay more to get bread. The baker then adjusts his prices upwards.

On a larger scale, when this dynamic extends to many products (milk, oil, various services), we witness a generalized demand-driven inflation.

The rising production costs

Cost-push inflation works differently. It occurs when production costs rise – without an increase in consumer demand.

Let's return to our baker, who has now succeeded in producing 4,000 loaves of bread per week. Everything seems balanced. But now a poor wheat harvest makes this raw material much more expensive. To maintain his production, the baker has to spend more. He has no choice but to raise his selling prices.

Other factors can trigger this type of inflation: an increase in the government-mandated minimum wage, a rise in taxes on goods, or a devaluation of the local currency making imports more expensive.

Hereditary inflation: when the past shapes the present

Embedded inflation (sometimes referred to as hangover inflation) emerges from previous inflationary cycles. It manifests when workers and companies, having experienced inflation in the past, expect to experience it again in the future.

Specifically, employees negotiate salary increases to anticipate this expected inflation. Companies, seeing their labor costs rise, increase the prices of their products. Workers, seeing prices go up, demand even higher wages. This is the wage-price spiral: a self-reinforcing cycle that is difficult to break.

How Governments and Central Banks Combat Inflation

Increase interest rates: the classic remedy

Most central banks ( like the U.S. Federal Reserve) control inflation by raising interest rates. A higher rate makes borrowing expensive and less attractive for consumers and businesses.

With expensive credit, individuals are more hesitant to spend, which reduces demand. Companies are also becoming cautious before investing. At the same time, saving becomes attractive as the offered interest rates are more rewarding. The result: a decrease in overall demand and, theoretically, a reduction in inflation.

The downside: this policy may slow economic growth by discouraging investment and consumption.

Modify the budget policy

Governments can also act on the public budget. By increasing income taxes, citizens have less money to spend. Demand decreases, and inflation theoretically recedes.

However, this approach is politically delicate - the public rarely reacts favorably to tax increases.

Quantitative easing: a double-edged sword

Central banks have other tools, such as quantitative easing (QE), through which they buy assets to inject fresh money into the economy. Paradoxically, this measure tends to worsen inflation by increasing the money supply. It is therefore not used to combat inflation, but rather to stimulate the economy during a recession.

The opposite, quantitative tightening (QT), reduces the money supply and could theoretically mitigate inflation, but empirical evidence of its effectiveness remains limited.

Measuring Inflation: The Consumer Price Index

How to know if inflation has become problematic? It must be measured. The most common tool is the Consumer Price Index (CPI).

The CPI tracks the prices of a wide range of consumer products purchased by ordinary households – food, housing, transportation, etc. It uses a weighted average to assess this “basket of goods and services.” This measure is conducted regularly, allowing for comparisons over time.

Let's take an example: if the CPI was 100 in the base year and reached 110 two years later, it means that prices have increased by 10% over two years. Organizations like the Bureau of Labor Statistics collect this data from businesses across the country to ensure accuracy.

Moderate inflation is not necessarily catastrophic – it is a natural phenomenon in contemporary fiat currency systems.

The Positive Aspects of Controlled Inflation

Encouragement of spending and investment

A slight inflation encourages individuals and businesses to spend rather than save. Why? Because saved money loses value. It is wiser to buy now rather than wait, since the same amount of money will have reduced purchasing power in the future. This dynamic stimulates the economy.

Increase in profit margins

Companies can justify price increases to protect themselves against inflation. If the situation allows, they may even raise prices more than necessary, thereby improving their profit margins.

Preferable to deflation

Deflation – the opposite of inflation – sees prices gradually decrease. Consumers, seeing prices drop, delay their purchases in hopes of better deals later. This caution dampens demand, hinders economic growth, and often leads to rising unemployment. Historically, periods of deflation have been associated with severe economic crises.

The risks of poorly managed inflation

Hyperinflation: when everything goes off the rails

Uncontrolled inflation can degenerate into hyperinflation – a situation where prices increase by more than 50% per month. Buying a staple product that cost 10 euros for 15 euros a few weeks later is concerning. But in hyperinflation, these increases become exponential, essentially rendering the currency useless. Individuals' wealth evaporates, and savings become worthless.

Growing economic uncertainty

When inflation reaches high and unpredictable levels, uncertainty sets in. Businesses and households do not know if their investments will be profitable, or if their salaries will still cover their needs. This uncertainty leads to excessive saving and discourages investment, slowing down economic growth.

Debate on Government Intervention

Some criticize the attempts of governments to “create money” to control inflation, arguing that it violates the principles of free markets and natural economies. These actors advocate for a less interventionist approach.

Conclusion: A moderate and managed inflation

Inflation remains an inevitable phenomenon in modern economies. The challenge is not to eradicate it, but to manage it. When well-managed, mild inflation stimulates spending, investments, and promotes economic growth.

Flexible fiscal and monetary policies allow governments to adjust their strategy and contain price increases. Nevertheless, these interventions require great caution – if poorly calibrated, they risk causing more harm to the economy rather than healing it.