Inflation is a phenomenon that may be difficult to grasp for some.

Here’s a basic guide to better understand its impact.

What is inflation?

Inflation is defined as the upward movement in the price of services and commodities over time. This movement affects all economies and erodes the value of their respective currencies. One of its major impacts can be felt through the rising cost of living.

For instance, the Reserve Bank of Australia (RBA), which sets an annual target for inflation rates in Australia, recorded that there has already been a rate increase of 0.4 per cent for the period December 2017 to March 2018. The quarterly increase seems negligible, but how would inflation look if it extends to a 20-year period?

RBA says that $1 and $1,000 items in 1997 increased to $1.66 and $1,663.05, respectively, by the end of 2017.

How inflation is measured

Inflation can be measured using price changes in a basket common commodities. This basket is called the consumer price index (CPI), and it quotes the representative price movements using the percentage price change.

In the above example, for instance, the period 1997 to 2017 registered an inflation rate of 66.3 per cent spread over 20 years, or an average annual rate of 2.6 per cent.

The Australian Bureau of Statistics (ABS) measures CPI based on a comprehensive but fixed set of commodities typically acquired by residents in the eight state capital cities. ABS regularly measures and updates the CPI figures and publishes it quarterly in its website.

Causes of inflation

To understand what causes inflation, we need to take a closer look at the relationship between supply and demand.

The basic premise of the law of supply and demand is that price increases when there is a higher demand than supply, and prices drop when supply is higher than demand. So how does inflation enter the picture?

The three primary causes of inflation are:

• Demand-pull inflation
• Cost-push inflation
• Monetary inflation

Demand-pull inflation
Demand-pull inflation happens when the aggregate demand increases faster than the aggregate supply in the economy.

An example of this is when imports decrease and exports increase. In this case, the decrease in local supply results in scarcity and a surge in prices—or in other words, demand for the limited supply pulls prices up and causes inflation.

Cost-push inflation
Supply can also decrease when the costs for producing commodities increase due to external factors, such as more expensive raw materials or wage hikes. When this happens, suppliers are forced to push their prices up to meet the cost increase in order to maintain their production capacity.

It also serves as the beginning of a series of increases that make inflation difficult to stop. There are three instances when cost-push inflation can happen.

These are:

• Wage-push inflation: When groups such as labour unions push for and successfully negotiate wage hikes which can lead to an increase in production costs.
• Profit-push inflation: This happens when monopolies or similar market structures push up the prices of their products in order to generate more profit.
• Supply shock inflation: This occurs when there is an unforeseen drop in supply of necessary commodities. This may sometimes happen after natural or man-made disasters that cripple the supply lines of major manufacturers.

Monetary inflation
Monetary inflation refers to the oversupply of money in the economy. This happens when a country’s central bank prints money excessively. Since money is also an item with an attached value, its value decreases when there is an oversupply.

Consider the scenario wherein a country with a population of one million circulates $10 million worth in their currency. If the government suddenly decides to print $90 million more so that there is $100 million in circulation.

The actual result is not that there is more money in the market, but that the prices of all commodities would increase to compensate for the oversupply. In the scenario above, prices could increase tenfold because the amount of money in circulation devalues the currency.

An extreme form of monetary inflation—hyperinflation—actually occurred in Germany in 1923, when a doubling of prices occurred every four days.

Is inflation a bad thing?

While inflation can devalue money and weaken purchasing power, the phenomenon is not always bad.

A healthy inflation—usually about two per cent—is a sign of a robust economy with continued growth. Moving past each government’s target inflation, however, can be bad for the economy.

This information has been sourced from the Reserve Bank of Australia and Australian Bureau of Statistics.