Inflation Explained: Causes, Effects, and Economic Impact

Inflation is a key aspect of the economy and plays a vital role in financial analysis. To understand its impact, it is vitally important to be familiar with its different manifestations, such as deflation and hyperinflation.

Central banks have the difficult task of maintaining a balance between economic growth and price stability. The vast majority follow one guiding principle: promoting employment while controlling inflation.

What Is Inflation?

Inflation can be defined as the phenomenon by which the prices of goods and services increase over time within an economy. Its name comes from the fact that prices “inflate” year after year, like a balloon.

Although price increases can often be negative, low inflation with a stable rate is considered beneficial for economic growth. Several economists indicate that a moderate level of inflation serves to minimize the impact of recessions by avoiding significant drops in prices.

For this reason, central banks set inflation targets. For example, the Bank of England maintains a target of 2% per year. If inflation falls below this number, interest rates can be reduced with the aim of stimulating both consumption and investment. On the other hand, if inflation is quite high, rates can be raised to try to cool the economy in an attempt to avoid possible hyperinflation.

What Causes Inflation?

The economist Robert J. Gordon developed the “triangular model,” which classifies the causes of inflation into three fundamental types: demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Inflation

This occurs when the purchasing power of consumers increases, creating demand for goods and services that exceeds the market’s capacity to supply them.

A clear example of this was during the COVID-19 pandemic, when government stimulus and shifts in consumer habits led to unusually high demand in sectors such as gardening and household products, causing prices to rise.

Cost-Push Inflation

This is generated when production costs increase, primarily due to the scarcity of raw materials.

A notable example was the global increase in energy prices following the start of the war between Russia and Ukraine in 2022. However, cost-push inflation is also commonly driven by rising wages and other production expenses.

Built-In Inflation

Also known as lagged inflation, it arises as a consequence of past periods of high inflation. When consumers and workers expect prices to keep rising, the pressure to increase wages persists, which in turn causes further price increases in a continuous cycle.

What Is Hyperinflation?

Hyperinflation occurs when inflation gets out of control, leading to extreme price increases and a collapse in currency value. Historical examples include Germany in the years preceding World War II, Russia after the fall of the Soviet Union, and Zimbabwe in the 2000s.

Hyperinflation creates a crisis of confidence in both the economy and the monetary system. For this reason, central banks closely monitor any signs of excessive inflationary growth. Some analysts have warned that expansionary monetary policies, such as the quantitative easing used in the 2010s, could contribute to such a scenario.

What Is Deflation?

Deflation is the complete opposite of inflation: prices fall, and inflation drops below 0%.

This can be beneficial for consumers but also poses risks for the economy. Lower prices reduce company profit margins, potentially leading to layoffs and decreased demand. This can trigger a deflationary spiral, where falling prices lead to higher unemployment and economic contraction.

To counter this risk, central banks typically implement expansionary monetary policies, such as cutting interest rates or injecting liquidity into the economy.

Reflation and Disinflation

Reflation and Disinflation: Movements in the Inflation Rate

• Reflation occurs when the inflation rate begins to rise following a period of deflation or low inflation.
  
• Disinflation happens when the inflation rate slows down but remains positive.
  

A relevant case is that of the Bank of Japan during the 1990s and 2000s, when it attempted to reverse prolonged disinflation with near-zero interest rates and quantitative easing. However, these measures failed to stimulate the economy as expected, leading to the stagnation known as the “lost decades.”

Impact of Inflation on the Foreign Exchange Market

Inflation has a direct influence on the value of a currency in the forex market. According to the purchasing power parity (PPP) theory, exchange rates adjust to maintain stable purchasing power between different countries.

When a country experiences high inflation, the purchasing power of its currency falls relative to countries with lower inflation. As a result, its currency depreciates. In response, central banks may intervene by adjusting interest rates to control inflation and stabilize the currency.

Inflation Expectations and Speculation

In the currency market, expectations play a major role, and inflation is one of the most influential factors. Investors constantly speculate on how inflation data might affect central bank decisions and, consequently, currency values. If they anticipate rising consumer prices, they may position themselves strategically in anticipation of possible interest rate hikes.

Conversely, if data suggests an inflationary slowdown, traders could expect interest rate cuts, which would weaken the currency. This interplay between expectations and speculation drives currency market movements and can shift rapidly.

Inflation and Interest Rates

Central banks use interest rates as their primary tool for controlling inflation. When prices rise too quickly, they may raise interest rates to reduce spending and cool the economy. This action can strengthen the local currency by attracting foreign investment seeking higher returns.

On the other hand, if inflation is too low, central banks can lower interest rates to stimulate credit and consumption, which may weaken the currency. Currency traders pay close attention to interest rate decisions, as they significantly impact currency behavior.

Advantages and Disadvantages of Inflation

Inflation is not always perceived as negative, as it plays an essential role in stimulating the economy. Central banks usually set an annual inflation target of around 2%, and any significant deviation from this figure can raise concerns.

Inflation can support economic growth by increasing the value of assets such as real estate and equities, thereby boosting investment returns. However, it becomes problematic if prices rise too quickly, making it harder for consumers to access essential goods and services.

Another drawback lies in how inflation is measured, as standard indicators like the Consumer Price Index (CPI) reflect broad averages without accounting for specific sectors. A more granular analysis would offer a clearer understanding of how inflation affects different consumer groups.

Conclusion

Inflation is a complex phenomenon that directly influences economic stability and people’s daily lives. While a moderate level of inflation is beneficial, uncontrolled inflation can lead to hyperinflation or deflation, both of which have serious consequences.

For this reason, central banks play a crucial role in implementing policies aimed at keeping inflation within optimal levels. Understanding these concepts is essential for analyzing economic behavior and making informed decisions in the financial sphere.