what-is-price-inflation

What Is Price Inflation?

Price inflation is when there is an increase in price levels for goods and services over a period of time within an economy.

As prices rise, a single unit of domestic currency can buy less goods and services.

Another form of price inflation is where the price of a good remain the same however the the amount received for that price decreases.

Price inflation is a very important measure used by central banks when determining monetary policies.

Causes Of Price Inflation

There are currently two main causes to inflation. These are ‘Demand-Pull Inflation’ and ‘Cost-Push Inflation’.

Demand-Pull Inflation is when there is an increase in the money supply faster than the supply of goods available for purchase.

With the supply of a product or service unable to keep up with the demand, this then leads to those products increasing in price.

Cost-Push Inflation is when the cost of producing a goods or service increases.

Increases in production costs could be caused by rising oil prices, wage rises and rising energy prices.

How Is Price Inflation Measured?

There are many ways to measure inflation, with many countries using their own method.

One of the main ways of measuring price inflation in the U.S. is the Consumer Price Index (CPI).

CPI data is calculated and published by the Bureau of Labor Statistics (BLS) monthly.

Other main ways of measuring inflation are Gross Domestic Product Deflator (GDP Deflator) and The Producer Price Index (PPI).

The Effects Of Price Inflation

Inflation can have both positive and negative effects and can effect each economy differently.

  • Decrease in the purchasing power of consumers
  • A discouragement to invest or save due to an uncertainty over future inflation.
  • A shortage of goods caused by consumers hoarding with a concern that prices might increase in the future.
  • Possible reduction in unemployment due to nominal wage rigidity.

How Central Banks Maintain Inflation Levels

If a central bank sees price inflation rising at a faster pace than desired, it will likely tighten monetary policy by increasing interest rates.

Higher interest rates should then encourage savings through higher returns and slow spending, which would slow price inflation.

Sometimes inflation can remain subdued over a period of time, in this case a central bank will loosen monetary policy by reducing interest rates.

By reducing interest rates, the central bank hope to encourage borrowing and investing to help fuel price inflation.

Central banks try to maintain a sustainable level of inflation (typically 2%) through monetary policy.

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