Why Does Inflation Happen and How Can It Be Fixed?

Have you ever heard your grandmother say, "Back in my day, a bag of Saeukkang cost just KRW 300"? That's because of inflation. Inflation is the decline in the purchasing power of a particular currency over time. In other words, money loses value and the prices of goods go up.

Inflation has some upsides, but excessive inflation is generally bad. Think about it: if the money you hold were to lose much of its value by tomorrow, would people still value money and try to save it? When the inflation rate rises sharply, the government steps in and rolls out new monetary and fiscal policies.

• Inflation is when a currency loses value and the prices of goods and services rise. It is the opposite of deflation, in which purchasing power rises and prices fall.
• There are three main types of inflation: 1) demand-pull inflation, 2) cost-push inflation, and 3) built-in inflation.
• The most commonly used inflation measures are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
• Because excessive inflation is harmful to the economy, governments and central institutions actively step in and roll out new monetary and fiscal policies.
• Depending on your point of view, inflation can be seen as either positive or negative.

What Is Inflation?

Inflation is a decrease in the purchasing power of a particular currency. When inflation occurs, the currency loses value and the prices of goods and services keep rising.

A relative price change usually refers to a rise in the price of one or two goods, whereas inflation refers to a situation where the prices of almost all items go up. Inflation is a long-term phenomenon: the rise in prices is not temporary but persistent.

Most countries measure inflation every year and usually publish the percentage change compared with the previous period. Inflation is measured in various ways depending on the types of goods and services. Inflation is the opposite of deflation, in which the inflation rate falls below 0% and purchasing power increases.

Why Does Inflation Happen?

When a currency loses value, prices rise and purchasing power for goods and services shrinks. Falling purchasing power affects ordinary people's cost of living and can hold back economic growth. Economists generally believe that inflation occurs when a country's money supply outpaces its economic growth.

Sounds a bit complicated? Let me put it simply. The biggest cause of inflation is an increase in the money supply. The supply of money (or the amount of currency in circulation) can increase when monetary authorities print more money or hand it out to individuals.

The money supply is expanded when government bodies officially devalue the fiat currency, or when they buy government bonds from banks on the secondary market, giving banks more reserves. As the money supply increases, purchasing power falls.

Inflation can also occur due to a supply shortage of a particular good that is in high demand. This leads to a rise in the price of that good and can create ripple effects throughout the economy. As a result, the prices of almost all goods and services can rise across the board.

There are three main types of inflation: demand-pull inflation, cost-push inflation, and built-in inflation. Other types of inflation exist, but here we'll cover the best-known one, the "triangle model" proposed by economist Robert J. Gordon.

The 3 Types of Inflation and Why They Happen

1) Demand-Pull Inflation

Demand-pull inflation occurs when the money supply increases and credit drives overall demand for goods and services beyond the economy's production capacity. In other words, demand outpaces supply, leading to higher prices.

For example, imagine a bakery that bakes 100 loaves of bread every day. It sells 100 loaves a day, but one day demand for bread suddenly surges. People have more money in their pockets, so they buy more bread. In that case, the bakery is quite likely to raise its prices naturally. The 100 loaves it makes each day (supply) will be snapped up quickly by consumers (demand), and people who come to the shop later won't be able to buy bread even if they want to. In other words, there will still be people who want bread even if the price goes up. Inflation that arises when demand outpaces supply like this is demand-pull inflation.

To sum up, in demand-pull inflation, individuals have more money, positive consumer sentiment leads to more spending, and prices rise as a result. In other words, a gap opens up between demand and supply, and prices go up.

2) Cost-Push Inflation

Cost-push inflation occurs when the costs involved in the production process of goods rise. When the money supply increases and the prices of raw materials or other assets in the market go up, the overall prices of goods rise. This means finished goods and services require more money to produce, which ultimately leads to higher consumer prices.

Let's take the bakery example again. The bakery imports its wheat from the United States. But this year's wheat harvest was so poor that wheat ran short everywhere. Because the wheat supply was insufficient, the bakery had to offer higher prices to get wheat, and so it needed more money to make bread. As a result, cost-push inflation occurs, with prices rising even though consumer demand hasn't increased. The cost of making bread goes up, and consumer prices rise.

3) Built-In Inflation

Built-in inflation is a type of inflation that arises from economic activity. It involves a process in which, as the prices of goods and services rise, workers and consumers expect prices to keep rising and demand higher pay and wages to maintain their standard of living. These wage increases lead to higher prices for goods and services, and higher prices for goods and services in turn create a cycle of demands for further wage increases.

How Is Inflation Measured?

Tracking the price of an individual product over time is easy, but the market doesn't consist of just one or two products. People need many services and products to live more comfortable lives. These include not only food, metals, and fuel, but also electricity, transportation, healthcare, entertainment, and more.

Inflation aims to measure the overall impact of price changes across a wide range of goods and services, expressing the level of price increases for goods and services over time as a single rate.

Inflation is usually measured by tracking an index over a set period of time. Many countries use the Consumer Price Index (or CPI) to measure inflation.

The Consumer Price Index (CPI) takes into account the prices of various consumer goods and uses a weighted average to assess the value of items and services purchased by households. Price index measurements are carried out regularly. Agencies such as the U.S. Bureau of Labor Statistics (BLS) collect this data from stores across the country to make the calculation as accurate as possible.

The CPI calculation works by treating the CPI score of a "base year" as 100 and, for example, setting the score two years later at 110. From this, you can conclude that prices rose by 10% over those two years.

How Can Inflation Be Fixed?

A country's monetary authority, such as its central bank, takes measures to keep inflation within certain limits and to ensure the economy runs smoothly.

Uncontrolled inflation can harm the economy. Governments and monetary authorities can address inflation by adjusting the money supply and changing monetary and fiscal policies.

A central bank (e.g., the U.S. Federal Reserve) can control the supply of fiat money by increasing or decreasing the amount in circulation. A typical example is quantitative easing (QE), in which the central bank buys bank assets and supplies newly printed money to the economy. However, quantitative easing can make inflation worse.

The opposite of quantitative easing is quantitative tightening (QT), which can lower inflation by reducing the money supply. However, there is no evidence that quantitative tightening is a good cure for inflation. In practice, most central banks control inflation by raising their benchmark interest rates.

1) Raising Interest Rates

When interest rates go up, borrowing money becomes more expensive. As a result, consumers and businesses cut back on credit loans. This ultimately reduces spending and lowers demand for goods and services.

During periods of high interest rates, saving becomes more attractive, and lending money to earn interest becomes a better choice. Raising interest rates is effective at controlling inflation, but it can slow economic growth because businesses and individuals cut back on credit for investment and spending.

2) Changing Fiscal Policy

Most countries use monetary policy to control inflation, but changing fiscal policy is another option. Fiscal policy refers to the government's adjustment of spending and taxes that affect the economy.

For example, if the government raises the income tax it collects, individuals' disposable income shrinks. As a result, demand in the market falls, and in theory inflation can decrease. However, this can also be a risky approach, since tax hikes can stir up negative public opinion.

Does Inflation Have Any Upsides?

At first glance, inflation may seem purely bad. However, inflation is a part of the modern capitalist economy and an essential element of it. Those who hold assets such as real estate or commodities may welcome inflation, as it pushes asset prices up.

1) More Spending, Investment, and Borrowing

As we saw earlier, a low inflation rate can help the economy by encouraging spending, investment, and borrowing. Because inflation means the same amount of cash will have less purchasing power in the future, it makes more sense to buy goods or services right away.

2) Higher Revenue

Inflation encourages businesses to sell goods and services at higher prices to protect themselves from its effects. These price increases lead workers to demand higher wages, which can in turn increase consumption and supply and lead to economic growth.

3) Better Than Deflation

Deflation is the opposite of inflation and refers to prices falling over time. Because prices are falling, consumers will be able to buy goods and services more cheaply in the near future. So it becomes more efficient to wait a bit before buying. As a result, demand for goods and services drops, which can hurt the economy.

Historically, periods of deflation have tended to bring higher unemployment and more saving instead of spending. Deflation isn't necessarily bad for individuals, but it tends to hold back economic growth.

What Are the Downsides of Inflation?

In truth, inflation has more downsides than upsides. If inflation isn't properly controlled, an economic crisis can hit, posing a major challenge to national finances and economic policy.

1) Currency Devaluation and Hyperinflation

Finding the right inflation rate is hard, and failing to control inflation can have devastating consequences. Ultimately, inflation erodes the value of the wealth individuals hold. If you have KRW 1 billion in your bank account now, its purchasing power could be cut in half in 10 years.

High inflation can also lead to hyperinflation. Hyperinflation occurs when prices rise by more than 50% in a single month. Paying $15 for daily necessities that cost only $10 ten weeks ago is far from ideal. But during hyperinflation, prices sometimes rise far more than 50%, which signals a fundamental failure of monetary and fiscal policy.

2) Uncertainty

A high inflation rate can increase uncertainty. Because individuals and businesses can't picture a positive future, they spend their money more cautiously, which leads to less investment and slower economic growth.

3) More Government Intervention

Some people oppose government attempts to control inflation on the grounds of free-market principles. They argue that the government "issuing new money" or "withdrawing it" undermines natural economic principles. However, when inflation occurs, intervention by central organizations such as governments and central banks becomes necessary.

Wrapping Up

Simply put, inflation can be described as the decline in a currency's value over time, causing prices and the cost of living to rise. Mild inflation isn't necessarily bad. Inflation is a natural phenomenon in today's fiat money system, and it is beneficial to some extent because it encourages spending and borrowing.

Still, it's important to keep a close eye on the inflation rate so that inflation doesn't hurt the economy. Well-controlled inflation can actually help the economy.

In today's world, the best way to address inflation is flexible fiscal and monetary policy from governments and central institutions. However, these policies must be implemented very carefully, or they can do even greater damage to the economy.