William Simon, U.S. Treasurer in the 70s, used to say that Americans had a love-hate relationship with inflation. We hated it, but we loved everything that caused it. Learn about the cost of living, the CPI, and how they determine the state of the economy.

Supply and demand

Everything starts with supply and demand for products. Everything, from your food to your car’s fuel, you consume stuff. You demand it. And by suing your demand and the current supply of each of those products, their prices are set.

The law of supply and demand states that, the greater the demand for a product, the higher its price. Also, as demand increases, so does production –so as to meet the increased demand-. Conversely, the less the demand, the lower the price (and production slows down).

You can see these rules clearly with seasonal produce, for instance: when there’s a good season, fruits are cheaper (there’s too big a supply). And when trees like coffee or avocados have fungal or parasite issues, supply lowers, making the prices go up.

The Consumer Price Index

Everything we buy has a fluctuating Price. Sometimes we just don’t notice. However, each country’s central bank needs to measure the prices we pay to determine if thing are going well with the economy at large.

One of the indicators that every central bank uses is the Consumer Price Index, or CPI. The CPI contains the prices of certain articles that are generally consumed in each country; this group of items is known as the ‘family basket’. The family basket is different in each nation, and may contain the prices of any of the following type of common goods:

• Food (a group of food stuff such as bread, milk, cereals, meats, etc.)

  

• Fuel
• Housing
• Transportation
• Medical insurance (In the United States)
• Entertainment
• Communication (internet, phone service)

The PCI shows the average cost of life in a country, and it’s therefore considered the best cost of living indicator, showing if there’s inflation or deflation.

Inflation

Inflation is the sustained increase of consumer prices over a period of time. Meaning, stuff becomes more expensive. It sounds bad, yet the reality is that it’s good for the economy. Let’s see why.

When there’s inflation, we consumer expect prices to continue going up. Here’s an example: you know that certain mobile phone is going to be one of the hot items next Christmas that they’ll be hard to find and pricier. Therefore, you buy yours now.

What happens then? Well, like you, many consumers decide to buy that phone now: demand goes up. The maker starts making more, so they hire more people to do that, and it’s good for economy. Everyone’s happy.

The other benefit of inflation that few suspect even if it’s obvious: it stops deflation. Because, if you think you dislike inflation, trust us: you like deflation even less.

Deflation

When you hear or read that the economy is slowing down, the central element in that statement is deflation. As you likely suspect, deflation is the sustained decrease in consumer prices over a period of time.

During deflationary periods, consumer expectations change. Let’s go back to that phone example. Prices are now going down. You want that phone, but know that if you wait, you might get it cheaper three months from now. What do you do? Like thousands of other consumers, you don’t buy because you want to pay less.

That mobile phone company? They stop making them because their supply is more than your demand; over time, they start cutting jobs. Those people consume less because they have less money, so that other companies also let go of their employees and so forth. This vicious circle is known as economic deceleration, or a depression.

The cost of living

The cost of living is what the average person spends to live. It differs in every country, city, and sometimes even among neighborhoods. That’s because everyone consumes as they can, and those who are better off, save.

When there’s inflation, everyone’s purchasing power goes down, and their cost of living goes up. This is why companies adjust salaries annually. Usually, the bare minimum is an adjustment for the cost of living. If you’re lucky, you get more than that.

What is all means is that daily consumption and people’s cost of living are what maintains a country’s economy alive. A healthy economy is that in which prices go up little by little; this leads to stable employment, since slight inflation still allows people’s o have a stable purchasing power. And their demand for products maintains and/or increases employment. Everyone wins.

Logically, deflation is the opposite of this, and that’s why it’s bad for the economy.

Hyperinflation

We finish today explaining a term that we hear often these days. Hyperinflation is the uncontrolled inflation of prices in an economy. Some economists define it as an increase in the CPI of over 50% every month for a year. According to the International Financial Reporting Standards, it’s the increase of over 100% in prices in an economy, continued over 3 years.

The first known case of hyperinflation took place in the Weimar Republic (which after would become Germany) after losing in World War One. The most recent is the ongoing case in Venezuela. In the past hundred years there have been about a dozen recorded cases of hyperinflationary crises worldwide.

It’s often associated to wars –or rather, the aftermath of war-, periods of social or political upheaval, or large economic depressions. It happens when a country’s central bank, in trying to repair the economy, prints too much money and injects it into the economy.

That excess cash makes prices skyrocket, because companies know that people have more money. The government then prints more money, and prices shoot up again, and so forth. The only way to stop this degenerative cycle is a combination of:

•  Economic measures (stimuli),
• Tax and economic reform,
• The adjustment of the currency’s value, and/or as it has happened sometimes,
• The creation of a whole new currency.