What is inflation?

Published: 20-10-2023

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One of the characteristic features of a market economy is the volatility in prices of goods and services. It is normal for prices to rise or fall depending on supply and demand. Inflation occurs only when price increases are widespread and permanent. This means that the price rise applies not only to individual goods but to most or even all goods and services, and that it is not a short-lived phenomenon but persists for a long time. From the household perspective, inflation is associated with a decline in the purchasing power of money. This means that your salary can buy fewer goods or services than before.

In the worst-case scenario, inflation can turn into what is known as hyperinflation. It is assumed that hyperinflation occurs when prices rise by at least 50 percent per month or 1000 percent per year and persist for several to several dozen consecutive months. Hyperinflation is usually associated with a collapse of state finances and other negative macroeconomic effects, such as a budget deficit, a slowdown in investment and high unemployment. The consequences of hyperinflation are painful for the entire population, in particular for people receiving social benefits (pensions, allowances, etc.), the adjustment of which does not fully compensate for the loss of their purchasing power.


Common reasons for price increases

In a market economy, prices are set by the interaction of supply and demand. Prices are determined by manufacturers and other producers of goods and services, and wholesalers and retailers who apply their markups, and free competition acts as a natural barrier to prevent excessive price increases. Price levels in the internal market are influenced by prices in international markets, both for imports and exports. Manufacturers and other producers of goods and services may raise prices to compensate for their higher costs related to wage increases, research and development expenditures, etc.

Prices may also depend on weather conditions: a good harvest means prices will fall; a poor harvest means they will rise. Inflation is also influenced by the economic policies of the government. Price increases are fueled by the fiscal imbalance, money-supply growth, excessive state funding and regulation, etc. State institutions such as ministries of finance and central banks exercise control over maintaining the inflation rate at a low and stable level.


How is inflation measured?

Inflation is measured using information on the prices of identical goods and services in comparable periods and the structure of household expenditure. Due to the fact that it is impossible to collect information on prices in all transactions carried out in a given period, economists create sets of goods and services, called market baskets, representing samplings of the items bought by consumers. Data on the amount of household expenditure on particular groups of goods and services are used to determine the average price level of particular groups of goods and services in a given period, while on the basis of data on the structure of this expenditure, a statistical weight is assigned to each group of goods and services. The price growth (inflation) rate is calculated by comparing the total value of the basket in a given period (e.g., a month) and in the same period of the previous year.

The basic measure of inflation is the Consumer Price Index (CPI), which refers to the increase in prices of goods and services most purchased by households. In the European Union, the Harmonized Index of Consumer Prices (HICP) is used. It is a measure of inflation that is comparable across Member Countries. The so-called core inflation is also used to measure inflation. This indicator measures price changes excluding the most volatile components (food and energy).


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