Why is your money becoming less valuable? Unveiling the truth about Inflation.

Have you ever heard your elders talk about the times when “prices were much cheaper”? There is an economic term behind this phenomenon — Inflation. This is not just an abstract concept; it directly affects the lives and savings of each and every one of us.

What is Inflation?

In simple terms, Inflation refers to the decrease in the purchasing power of the currency in your hands. When the prices of goods and services continue to rise, the same 100 euros will buy you less a year later. This phenomenon is different from mere price fluctuations— the latter may only affect certain goods, while true Inflation leads to rising costs for almost all goods and services in the economy.

More importantly, inflation is a long-term trend rather than a short-term event. Governments usually measure the inflation rate annually, typically expressed as a percentage relative to the increase or decrease from the previous period.

How does Inflation occur?

Understanding the fundamental causes of Inflation requires starting from two basic mechanisms:

First reason: Excess money supply

When the amount of currency in circulation increases dramatically, Inflation often follows. A classic historical case is the 15th-century European conquerors bringing back large amounts of gold and silver from the Americas. The influx of these precious metals into the European market led to a surge in the money supply, ultimately triggering severe Inflation.

The second reason: Insufficient supply of goods

When the demand for a certain product exceeds its supply, prices will rise. This shortage can spread throughout the entire economic system, leading to broader price increases.

The “triangle model” proposed by economist Robert Gordon categorizes Inflation into three main types:

Demand-pull Inflation

This is the most common form of Inflation. When overall spending in society increases and demand exceeds supply, merchants will raise prices.

Imagine a bakery where the ovens and staff can produce a maximum of 1000 loaves of bread per week. Business has been stable. Suddenly, one day, the economic situation improves, and consumers have more disposable income, leading to a surge in demand for bread. The baker now faces a dilemma: the quantity of bread he can produce hasn't changed, but the number of buyers has increased. Some eager customers are willing to pay a higher price to obtain the bread. The result? Prices have risen.

When this demand growth affects various goods such as milk, oil, and flour, you see the real demand-pull Inflation — the prices across the entire market are rising.

cost-push Inflation

Different triggering mechanisms may lead to another type of Inflation. This time, it is the rise in production costs that “pushes up” the prices consumers have to pay.

Continuing with the example of the bakery. Suppose the baker has just expanded production capacity and can now produce 4,000 loaves of bread per week. Demand is being met, and the market is stable. But suddenly, a poor wheat harvest causes flour prices to soar. The baker is forced to pay more for procurement costs, and therefore must raise the price of bread—even though consumers' actual demand has not increased.

Cost-push inflation may also be caused by other factors: the government raising the minimum wage standard (increasing enterprise wage costs), rising crude oil prices (affecting transportation costs), or currency depreciation (making imported goods more expensive).

Endogenous Inflation

This is the most “sticky” type of Inflation, stemming from past economic activities. It is closely related to two psychological economics concepts:

Inflation Expectations: Once individuals and businesses have experienced a period of high inflation, they begin to believe that high inflation will continue in the future. Employees will demand higher wages to protect their purchasing power, while businesses will raise prices to offset rising costs.

Wage-Price Spiral: This is a self-reinforcing vicious cycle. It occurs when workers demand higher wages to cope with rising prices, and employers respond by raising the prices of goods to cover the increased wage costs. The result is that workers again demand higher wages, prices rise again… and the cycle repeats.

How does the government combat Inflation?

Out-of-control Inflation has caused serious damage to the economy, so the government and central bank have taken various measures to control it. The main tools include adjustments to monetary policy and fiscal policy.

The power of raising interest rates

The most commonly used tool by central banks (such as the Federal Reserve) is to raise the benchmark interest rate. When the cost of borrowing increases:

• Impact on Consumers: Loans have become more expensive, while savings are more attractive. Consumers will reduce spending, thus lowering the demand for goods and services.
• Impact on Businesses: High interest rates increase the cost of financing for business expansion, leading companies to invest more cautiously, which may affect economic growth.

This trade-off is necessary: controlling price increases by suppressing spending, but the risk is that it may hinder economic growth.

Adjustment of fiscal policy

In addition to the central bank's monetary policy, the government can also intervene through fiscal policy. Increasing taxes can reduce people's disposable income, thereby lowering market demand. However, this path is fraught with danger—public resentment towards tax increases may lead to political backlash.

How to Measure Inflation?

To determine whether inflation needs to be controlled, it must first be measured. Most countries use the Consumer Price Index (CPI) as the primary measurement tool.

CPI tracks the price changes of a basket of consumer goods and services, using a weighted average to reflect the purchasing habits of the typical household. Agencies like the U.S. Bureau of Labor Statistics regularly collect data from stores across the country to ensure accuracy.

The calculation is simple: set a certain year as the “base year,” with the CPI at 100. If the CPI rises to 110 two years later, this means that prices have increased by 10%.

Low levels of Inflation are actually viewed as healthy by many economists. In modern fiat currency systems, moderate inflation encourages people to spend and invest rather than hoard cash.

The Duality of Inflation

Benefits You May Not Know

Stimulating Economic Activity: Moderate inflation encourages people to buy immediately, as delaying purchases means getting less for the same amount of money. This drives consumption and investment.

Opportunities for Corporate Profits: While inflation has increased costs, companies can also sell their goods at higher prices. If they can justify these price increases, they may even be able to charge a premium to gain more profits.

Superior to Deflation: Deflation (price decrease) may seem attractive, but in reality, it does more harm. When prices fall, consumers tend to delay purchases in anticipation of even cheaper prices, leading to a collapse in demand and rising unemployment rates. Historical periods of deflation are often accompanied by economic recessions.

The serious hazards of high Inflation

Wealth Erosion: If you store 100,000 euros under your mattress, its purchasing power will significantly decrease after ten years. In extreme cases, hyperinflation (monthly price increases exceeding 50%) can destroy a country's currency value and economy. During hyperinflation, the prices of essentials can double within weeks.

Economic Uncertainty: In a high inflation environment, individuals and businesses cannot predict future costs, leading them to become cautious and conservative. Investment and economic growth will be hindered.

Government Intervention Controversy: Some economists oppose the practice of the government controlling inflation by “creating money”, arguing that it violates the principle of market freedom. In the cryptocurrency community, this policy is often sarcastically referred to as “printing money” (Brrrrr).

Final Thoughts

Inflation is an inevitable phenomenon in modern economies. It is neither an absolute evil nor harmless. The key is control - moderate inflation can promote economic health, but uncontrolled inflation can cause disaster.

The most effective contemporary measures seem to be adopting flexible monetary and fiscal policies, allowing governments to make rapid adjustments according to economic conditions to curb excessive price increases. However, this needs to be executed with caution, as excessive policy adjustments can also harm the economy. Understanding the mechanisms of Inflation has become increasingly important for anyone looking to protect their wealth.