What is Inflation
Inflation is how fast prices are rising. A few ways to think of inflation is like how quickly a car is accelerating, where the car is the economy and acceleration is how quickly the car is gaining speed.
There are three types of inflation:
Demand pull inflation is from credit causing people to demand more goods and services
Supply push effect - is from prices from businesses rising because the cost of inputs increasing
In-built inflation - is when people ask for higher wages or more money in anticipation of future inflation
Why we care
Too high Inflation can have negative effects which are:
Inflation reduces wealth for assets like houses or cash which are not indexed by inflation
Reduces your standard of living by making the things you buy more expensive you end up buying less and that can mean sacrificing some purchases.
The way we spend and invest becomes distorted. If we expect prices to increase we spend more now for example people queue for fuel today because they expect price rises tomorrow which makes prices rise!
Causes self-fulling inflation. For example workers believe future cost of living will be high so they demand more wages, but those wages cause prices to rise resulting in a vicious cycle.
Deflation better
Would deflation be better. No, just like Goldilocks the inflation rate needs to be just right. Too low of inflation or deflation would mean:
People delay spending which could the economy to slow down even further. For example, if you expect a house to be cheaper in a month, you might worth a month to get a better price,
People may not spend or invest if the value of the asset will fall in value,
Business will layoff works for one to hire cheaper workers or to reflect the reality business is going slower,
Debt becomes more expensive which makes people scared to invest or spend.
The majority of the thinking is deflation is worse than high inflation
The goldilocks inflation rate is around 2 to 3 per cent. This rate is seen as not to influence people's choices the least.
Australia has a target of 2 to 3%, South Africa, 3 to 6%, USA has a target of 2% and UK at 2%.
Other countries do have higher targets that are suitable for the growth and development they want to achieve Nigeria has a target of 6 to 9%, South Africa, 3 to 6%, and Egypt has flexible target is currently 7%
How to Control inflation
Interest Rates is the common way of controlling inflation. By raising and lowering interest rates the price of credit becomes less or more expensive and makes saving more or less appealing. But interest rates transfer money from people and businesses to financial lenders.
Keynes advocated for an alternative. Another way is mandating savings so people can spend their money later. This has been done in Australia through superannuation. People had money saved to spend in retirement.
Government spending could increase or decrease to regulate inflation but the disadvantage government spending is slow to make an effect and arbruptly cutting spending can have massive consequences.
Other options include monetary targeting and exchange rate targeting which are explained in this article.