Inflation is a word that often makes people nervous. It sounds like something bad that happens to your money, and you don’t want that. But what exactly is inflation, and why does it matter?
In this article, we will explain what inflation is, what causes it, how it is measured, what are its effects, and how it can be controlled. We will also explore some of the connections between inflation and blockchain and cryptocurrency.
What causes inflation?
Inflation can be defined as the decrease in the purchasing power of a given currency. It is a phenomenon of persistent increase in the prices of goods and services in an economy. “Relative price changes” usually refer to the price increase of only one or two goods, while inflation means that the costs of almost all goods in the economy are increasing. Moreover, inflation is a long-term phenomenon, where price increases occur continuously, and not just as isolated events.
Most countries measure the inflation rate on an annual basis. Usually, inflation is expressed as a percentage change: the increase or decrease relative to a previous period.
At the most basic level, we can describe two common causes of inflation. First, the actual amount of money in circulation (supply) increases rapidly. For example, when European conquerors conquered the Western Hemisphere in the 15th century, a large amount of gold and silver flooded into Europe, causing inflation (excess supply). Second, there may be a shortage of supply for certain goods with high demand, which may trigger inflation. This may then cause the price of that good to rise, and other areas of the economy may be affected. As a result, the prices of almost all goods and services may rise in general.
But if we dig deeper, we can describe different types of events that may cause inflation. Here, we will distinguish between demand-pull inflation, cost-push inflation, and intrinsic inflation. There are many other variants, but these are the main ones in the “triangle model” proposed by economist Robert J. Gordon.
Demand-pull inflation
The most common type of inflation is demand-pull inflation, which is caused by an increase in spending. In this case, the demand is greater than the supply of goods and services, which leads to price increases.
We can use the example of a baker selling his goods in a market to illustrate this. He can make about 1,000 baguettes per week. His business is doing well, as he sells about that many baguettes every week. But suppose that the demand for bread increases significantly. Perhaps the economic situation has improved, which means that consumers have more money to spend. In that case, we are likely to see an increase in the price of the baker’s bread. Why? Well, our baker is operating at full capacity, producing 1,000 baguettes. His staff or oven can’t go beyond that number. He can buy more ovens, hire more staff, but that takes time. In the meantime, we have more customers than bread. Some customers are willing to pay more for bread, so it makes sense for the baker to raise his prices accordingly.
Now, besides the demand for bread increasing, think about how the improved economic situation may also increase the demand for milk, oil, and several other products. This is the definition of demand-pull inflation. People are buying more and more goods in a way that exceeds supply, which leads to price increases.
Cost-push inflation
Cost-push inflation occurs when the prices of raw materials or production costs increase, leading to an increase in the price level. As the name suggests, these costs are “pushed” onto the consumers.
Let’s revisit our baker. He bought new ovens, hired more staff, and now produces 4,000 baguettes per week. The supply meets the demand, and everyone is happy. One day, the baker hears some bad news. The wheat harvest this season was particularly bad, which means that there is not enough supply to meet the demand of all the bakeries in the region. The baker has to pay a higher price to buy the flour he needs to make bread. Because of this increase in expenses, he has to raise the price of his bread, even if the consumer demand has not increased.
Another possibility is that the government raises the minimum wage. This would increase the production costs for the baker, and he would have to raise the price of his products again.
At the macro level, cost-push inflation is usually caused by a shortage of resources (such as wheat or oil), an increase in taxes by the government, or a depreciation of the exchange rate (which increases the cost of imports).
Intrinsic inflation
Intrinsic inflation (or inertial inflation) is a type of inflation that is caused by past economic activity. Therefore, if the previous two forms of inflation persist for a long time, they may trigger this type of inflation.
Intrinsic inflation is closely related to the concepts of inflation expectations and the price-wage spiral. The former describes the idea that individuals and businesses expect inflation to persist in the future, after experiencing it for a while. If there was inflation in the previous years, workers are more likely to negotiate higher wages, which leads to businesses raising the prices of their products and services.
The price-wage spiral concept explains the tendency of intrinsic inflation to cause more inflation. This may happen when employers and employees cannot agree on the value of wages. Employees want higher wages to protect their wealth from the expected inflation, while employers are forced to raise the prices of their products. This creates a self-reinforcing cycle, where employees demand higher wages to cope with the rising prices of goods and services, and this cycle continues.
How to measure inflation?
So, we have outlined some of the measures to combat inflation, but how do we know that we have to fight inflation in the first place? Obviously, measurement is needed first.
Usually, this is done by tracking an index over a set period of time. In many countries, the Consumer Price Index (CPI) is the preferred indicator for measuring inflation. The CPI takes into account the prices of various consumer goods, and uses a weighted average to assess the value of a household’s purchase of a range of goods and services. This is done every once in a while, and then the index values can be compared with historical values.
Entities such as the Bureau of Labor Statistics (BLS) in the US collect this data from stores across the country, to ensure that the calculations are as accurate as possible.
You may see the CPI value of a “base year” as 100, and then the index value two years later as 110. You can then conclude that prices have increased by 10% over the two years.
A small amount of inflation is not necessarily a bad thing. It is a natural phenomenon in the current fiat currency system, and it is beneficial to some extent, as it encourages consumption and borrowing. However, it is important to closely monitor the inflation rate, to ensure that it does not have any negative effects on the economy.
How does inflation affect the economy?
Inflation has both positive and negative effects on the economy, depending on its magnitude and duration. Some of the advantages and disadvantages of inflation are:
Advantages of inflation
Inflation can stimulate economic growth, as it encourages consumers to spend more and save less, and businesses to invest more and increase production.
Inflation can reduce the real value of debt, which benefits borrowers and hurts lenders. For example, if you borrow $100 today and the inflation rate is 10%, you will have to pay back $110 in nominal terms, but only $100 in real terms.
Inflation can increase the competitiveness of exports, as it makes domestic goods cheaper relative to foreign goods. This can boost the trade balance and the GDP of a country.
Disadvantages of inflation
Inflation can erode the purchasing power of money, which means that consumers can buy less goods and services with the same amount of money. This reduces the standard of living and the welfare of the population.
Inflation can create uncertainty and instability in the economy, as it makes it harder for consumers and businesses to plan ahead and make rational decisions. This can reduce the efficiency and productivity of the economy.
Inflation can distort the allocation of resources, as it creates price signals that do not reflect the true scarcity or abundance of goods and services. This can lead to overproduction or underproduction of some goods, and create market failures.
What is the relationship between inflation and blockchain and cryptocurrency?
Blockchain and cryptocurrency are often seen as alternatives or solutions to the problems of inflation and fiat currency. Some of the reasons for this are:
Blockchain and cryptocurrency are decentralized and transparent, which means that they are not controlled or manipulated by any central authority or intermediary. This prevents the possibility of inflation caused by excessive money creation or currency devaluation by the government or the central bank.
Blockchain and cryptocurrency are based on cryptography and consensus mechanisms, which ensure the security and validity of the transactions and the data on the network. This reduces the risk of fraud, corruption, and counterfeiting, which can also cause inflation.
Blockchain and cryptocurrency have a limited or predictable supply, which means that they are not subject to inflation due to excess demand or scarcity. For example, Bitcoin has a fixed supply of 21 million coins, which will be reached around the year 2140. The issuance rate of new bitcoins is also predetermined by the protocol, and it decreases by half every four years. This creates a deflationary pressure on the price of bitcoin, as the demand increases over time.
Blockchain and cryptocurrency can also provide alternative ways of measuring and managing inflation, by using smart contracts, oracles, and stablecoins. Smart contracts are self-executing agreements that run on the blockchain, and can be used to create inflation-indexed contracts, such as loans, wages, or rents. Oracles are entities that provide external data to the blockchain, such as the CPI or the exchange rate, and can be used to adjust the contract terms according to the inflation rate. Stablecoins are cryptocurrencies that are pegged to a fiat currency or a basket of assets, and can be used to hedge against inflation or volatility.
Conclusion
Inflation is a complex and multifaceted phenomenon that affects the economy and the society in various ways. It is important to understand its causes, effects, and measurement methods, as well as the possible solutions and alternatives. Blockchain and cryptocurrency are some of the emerging technologies that offer new perspectives and opportunities for dealing with inflation. However, they also face some challenges and limitations, such as scalability, regulation, and adoption. Therefore, it is essential to keep an open mind and a critical eye, and to explore the potential and the pitfalls of these innovations.