Picture a bicycle tyre. With too little air in your tyres, you'll struggle to pedal and your bike will be harder to control. Too much air in your tyres may cause them to burst. Every cyclist knows that they must keep the optimal amount of air in their tyres to ride safely and prolong their wheels' rubber sheath. Unfortunately for cyclists, everything from ambient temperature to their tyres' age impacts their air content.
The economy must also be optimally maintained:
- If there is too little currency circulating, the economy won't grow.
- If there's not enough demand for the available goods and services, the economy will falter.
- If there's too much demand regardless of supply, the economy will destabilise
- If there's not enough of anything to go around, the economy will suffer.
A cyclist will add or let air out of their tyres as needed to ensure a smooth, safe ride. Economic actors will nudge the economy this way and that, to make sure it stays on the desired course. Inflation is one of the indicators economists and policymakers use to keep the economy steady.
What Does Inflation Mean?
Generally speaking, inflation is a rise in prices for goods and services. In itself, that's an inoffensive concept. The flip side of rising prices means consumers can afford to buy fewer goods and services. So, inflation is also the loss of buying power (also called purchasing power).
Not all prices rise at the same time, for the same reasons or by the same amount. For instance, the war in Ukraine is causing wheat prices to rise, which makes the price of bread UK more expensive. However, the supply of other grains is not affected by the war. Their prices go up for different reasons, and by different percentages.
With so many factors causing inflation, it can be difficult to measure. The inflation rate is tracked as a yearly percentage change in a price index. These indexes monitor the prices for categories of goods - grains, electronics and so on, in a specific region and over time. This consumer price index (CPI) gives a snapshot of how the economy fares over the year.
The economy is in for a hard time with high inflation and hyperinflation - a high, fast inflation rate. By contrast, the effects of low inflation can be good or bad, depending on the reasons for it. Economists prefer to see moderate inflation so everyone, producers and consumers, can budget ahead of the annual UK inflation forecast.
How Does Inflation Work?
Let's say you just discovered a marvellous new restaurant. And the prices are reasonable, too! You gush about it your to all friends. Too bad you'll too busy to eat there again, at least for a while! Next month, when you return, you're dismayed to find the prices higher than they were on your first visit. You mask your disappointment as the restaurant's owner thanks you for sending so much business their way.
This scenario contains practically every factor that drives inflation. At first, the restaurant wasn't popular so the owner didn't have to buy many supplies or pay their worker(s) very much. This low-demand, high-supply situation forced the owner to keep menu prices just high enough to cover expenses.
As more diners turned up to eat, the owner inflated his prices to afford more supplies (and maybe start turning a profit). And then, the restaurant's workers demanded more money for the extra work serving all of the new guests, which causes the restaurant owner to raise prices yet again. They may even have to resort to shopping around for lower ingredient prices.
Such an oversimplification neatly explains how inflation works. You can substitute governments and central banks for the restaurant owner. To control inflation, they use fiscal and monetary policies that raise and lower the supply of currency in circulation, taxes and bank interest rates.
The restaurant's supplier is the only economic actor not featured in our tale. They may need to raise their prices due to inflation. That makes the restaurant owner pay more for ingredients. Shipping also factors in. It might cost more to ship the ingredients or shipments could be delayed, forcing the restaurant owner to replenish their stocks, likely at a higher cost, even if they'd already paid for the ingredients held up in transit.
The Negative Effects of Inflation
As stated above, when prices go up, purchasing power goes down. Your wages may stay the same but they've effectively been cut because you can't buy as much. One of two things happens in inflationary times. People want to make the most of the money they have so they buy a lot of non-perishable goods. Economists call this hoarding. This excess demand tends to reduce the supply of goods, a cause of demand-pull inflation.
Inflation particularly harms low-income households. They have to spend more of their cash on basic necessities. By contrast, wealthier households have more assets, which increase in value during inflation. On the global scale, wealthier nations tend to fare better than poorer ones because they have the resources to weather economic downturns. Inequality is one of the most serious negative effects of inflation.
Following fiscal policy, the government may cut spending to curb rising inflation. Such a move may leave social programs like unemployment payments and household energy subsidies underfunded. Or they could raise taxes. Monetary policy dictates regulating the supply of money in the economy. The Bank of England (BoE) may raise interest rates to discourage borrowing. All of these inflation control measures ultimately harm consumers.
Is Inflation Bad?
With all that said, inflation is not all bad. It depends on the causes of the inflation event. Right now, the UK inflation forecast is particularly dire because several economically-impactful things happened one after the other. COVID is just one of the events that decimated economies around the world.
Increased spending is one positive effect of inflation. Consumers who had been putting off the decision to buy a big-ticket item like a car, electronics or major home appliances are more likely to do so before inflation gets really bad. Those who have money to invest look for high-yield, long-term financial instruments. In a sense, that strategy keeps their money out of harm's way while still building wealth for them.
Reducing high-level debt is probably the biggest positive aspect of inflation. Any debt holder - consumer, business or government, repaying their loan at a fixed interest rate benefits from inflation as long as the interest rate is below the inflation rate. This is especially true when the debtor's income rises in step with inflation.
Why Is Inflation Important?
Those seem like paltry gains when stacked against the huge losses inflation provokes. Also, if governments and central banks can manipulate the economy at will, what do they need inflation for? Because, in the grand scheme of economics, inflation is important to economic stability.
As long as it's well managed, inflation drives economic growth. Economists prefer inflation rates of one- to two per cent, year on year. Maintaining a low inflation rate reduces the negative impacts of economic recessions. It allows labour markets to adjust more quickly to economic shifts by managing employment levels and wage hikes.
Well-managed inflation prevents liquidity traps. Those are phenomena wherein economic actors keep cash rather than take on debt. Liquidity traps make it impossible for monetary policy to nudge the economy back to stability. The point of said policy is to control the supply of money so if everyone is hanging onto their cash, the central bank cannot exercise control over it.
Low inflation is more desirable than no inflation (zero inflation) and far better than deflation. Deflation occurs when prices for goods and services fall. It also raises the value of currency. Currently, a pound note might buy £0.58 worth of goods. Under deflationary conditions, every pound note might buy £1.10 worth of goods, or whatever the percentage rate of deflation is.
That sounds like a fine idea until we realise that the UK's economy is debt-driven. The principle behind a debt-driven economy is gross domestic product (GDP) growth and innovation. Those initiatives cost money, which has to come from somewhere. The solution was (and remains) debt. Since around the 1980s, most nations' economies have been debt-driven.
Deflation might seem like a solution tailor-made for these inflationary times. However, it would expose the real value of global economies' debt - as opposed to debt values adjusted for inflation. Such exposure could trigger and/or aggravate recessions.
Deflation may also cause consumers to hang onto their cash to see how far prices drop. This spending slowdown creates low demand, which causes producers to stop producing, leading to labour furloughs. With less coming in, consumers stop spending, which causes further price reductions. Deflation spirals are devastating; the Great Depression is the best representation of that principle. Fortunately, as those in power know all about inflation, they are doing everything to prevent another such occurrence.
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