Inflation’s Impact on an Economy

Inflation measures the rate at which prices in an economy are rising. Inflation is tied directly to the purchasing power of a currency within its borders and affects its standing on the international markets. Prices of goods, houses, labour, production materials, etc., are all closely monitored to see if their prices are increasing or not, and at what speed. Inflation can come about for different reasons.

Very Fast Growth in an Economy

In one simple example, inflation can start rising as a result of unchecked growth in an economy. Fast economic growth increases the amount of money printed and circulated throughout the economy. Extra money is necessary because consumers are taking money out of their banks and purchasing products. If businesses and stores are bringing in larger revenue and profits, then it can be expected that workers’ wages will increase as well. As wages increase, consumers go out and buy even more goods.

Businesses that did not benefit from the initial extra economic activity see that the consumers, with their extra wages, have more money. They purchase more of other goods now expanding the economic activity to other sectors. In order to keep up with the extra demand the businesses may choose to raise their prices.

If these cyclical prices changes are not contained, then it takes away from the actual economic growth of the economy, as on paper people have more money, but the money buys less goods due to higher prices. For example, a retired person with retirement funds in a bank will be adversely affected if prices start rising because that nest egg is not able to buy the same amount of goods prior to inflation.

Volatile Items

In a second example, inflation can be set off by an increase in the price of just one crucial item, such as energy. If the price of oil went up, many other items that use oil in their production process will increase in price. Not only that, but consumers and businesses have to spend more of their incomes and revenues to pay for the same amount of gasoline (a products that uses oil). Inflation erodes the purchasing power of their currency. Since an economy such as the US is heavily dependent on oil for its economic activity, a rapid rise in energy costs could begin a period of inflationary pressure.

Curbing Inflation

Inflation is troublesome. It is the job of the central bank of an economy to manage price stability. The main tool that central banks have is the power to set the country’s base interest rate. If inflation is running high, a central bank would raise rates in order to cool economic activity, and hopefully stem inflation. If inflation is low and the central bank wants to stimulate economic growth, they might lower rates. Since inflation has such a direct impact on a country’s interest rates policy it is very important in the currency markets.

Inflation Indicators:

Consumer Price Index

The Consumer Price Index measures the average price level of a basket of goods and services that are purchased by consumers. Changes in the CPI represent the inflationary pressures surrounding the economy. The CPI figure is probably the most crucial indicator of inflation within the United States. Consumers buy goods and use services and the changes they experience in prices will reflect the inflation in the economy.

Producer Price Index

The Producer Price Index measures the average price level for a fixed basket of capital, rent and materials needed for producers to manufacture consumer goods. Just as the CPI measures the prices from a consumer perspective, the PPI measures the prices at the producer level. PPI can show inflation before CPI because it will influence consumers next as they purchase these more expensive goods and services. Part of the inflation at the producer level is passed onto the consumers and therefore influences the CPI figure.

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This indicator measures the change in worker’s wages. It sheds light on consumers’ disposable income and on the costs to firms for their labour. Changes in wages also highlight the tightness of the labuor market, as firms will have to pay their skilled workers more to retain them.