What are the negative effects of inflation

Inflation: definition, meaning and examples

US inflation rose to its highest level in 13 years in April 2021. Members of the US Federal Reserve (Fed) recently emphasized that the price increases triggered by the boom in the economy after the corona lockdowns were only of a temporary nature. Nevertheless, the situation on the financial market in particular is causing nervous prices.

In Germany, too, consumption is increasing and demand is increasing in many places - sometimes in the chemical, steel and automotive industries. This meets with low stocks. This in turn increases prices and drives inflation worries. But when do economists actually start talking about inflation? You can find the most important questions and answers here.

Three facts about inflation

  • Prices go up and money goes down in value
  • Inflation is seen as a macroeconomic problem
  • Most of the time there are multiple causes

I.inflation by definition

Put simply, money loses value in the event of inflation, as the price level rises within an economy. Accordingly, an average of many prices must first increase for the term to actually apply. So-called unit price increases - for coffee, for example - are excluded from this. So if the coffee in the supermarket costs more in the short term, nobody is talking about inflation. Because by definition, inflation is always an ongoing process.

In summary, inflation is defined by both general and constant price increases. This inevitably means that people can afford less for their money. Or to put it another way: The purchasing power of money is decreasing.

Inflation and Deflation: What's the Difference?

While inflation describes the general and sustained rise in prices within an economy, deflation describes the exact opposite. The price level is falling. The value of money increases. In the case of deflation, the inflation rate is then negative.

Both inflation and deflation can have a negative impact on a country's economy - even if they have different causes.

What are the causes of inflation?

Several causes can devalue the money. Basically, the following factors influence inflation.

Lack of offer: If a raw material is only available in small quantities, the price usually rises. This form of inflation can sometimes be imported due to a high level of dependence on other countries and their raw materials. For example, Germany is dependent on the oil of other countries. If trade relationships are inhibited or delivery bottlenecks occur, the whole thing also affects us in terms of price.

At the same time, monopolists can use their market power to drive prices up. Conversely, consumers postpone costly investments as they hope for lower prices again.

Increased demand: Prices rise when certain goods are in greater demand and the suppliers cannot meet demand despite full production. This is a demand inflation. Corresponding trends are particularly evident in times of economic boom.

Increasing money supply: If a central bank increases the amount of money within an economy, for example to promote liquidity, inflationary prices can arise. If the amount of money exceeds the amount of goods disproportionately, the price level increases accordingly. A comparable scenario emerged in Germany after the First World War.

Consequences and Effects of Inflation

The amount of money and the prices for goods of all kinds should be as stable as possible. Because a sustained rise in the price level has consequences.

  • Companies and private individuals invest less
  • There is less demand, which for reasons of cost forces companies to further increase their prices
  • Real interest rate trap: Increased inflation in combination with the low interest rate policy of the European Central Bank (ECB) results in a negative real interest rate for some types of investment - for example, the money in the current account loses value

How is the inflation rate calculated?

A representative, fictitious shopping basket is used to calculate the inflation rate. This contains all goods that private households consume over the course of a year. Including groceries, rent or leisure expenses. As a rule, this basket of goods is rebalanced every five years. The following applies here: products for which a household generally spends more money are given greater weight. Electricity weighs heavier than salt in this basket.

Since not all people have the same purchasing habits, the weight of the goods is based on the average spending habits of all households. This in turn results in a national consumer price index (CPI) whose change compared to the same month last year reflects the inflation rate. For 2021, economists are forecasting an inflation rate in Germany of 0.9 percent. In 2022 it should be 1.3 percent.

Read here how the inflation rate in Germany has developed over the past few years.

In addition, other forms of inflation rates can be calculated. For example, the concept of core inflation is based on what is known as a core inflation rate. This hides product groups whose prices are particularly unstable. The result is an adjusted inflation rate.

In the European Union, on the other hand, the Harmonized Index of Consumer Prices (HICP) serves as a uniform calculation basis for comparing price changes internationally - and for calculating an overall inflation rate for Europe. The European Central Bank uses the Harmonized Index of Consumer Prices to assess price stability within the EU. According to the ECB, prices are stable when the annual inflation rate is below 2 percent in the medium to long term.

Does corona cause inflation?

The VAT cut in the wake of the corona pandemic initially pushed prices in Germany down in 2020. In addition, the energy costs fell. Both of these resulted in a low inflation rate (also: annual inflation rate) of 0.5 percent last year.

The corona crisis initially had a deflationary effect. Since a strong economic upswing is expected after the pandemic, some economists assume that prices will rise significantly in the medium to long term. At the same time, the huge Corona rescue packages and the scarcity of certain goods are factors that drive prices up and increase inflationary pressure.

In the short term, however, these effects should fizzle out. For the year 2022, the majority of forecast inflation rates in Germany will be below 2.0 percent. Long-term effects of the corona pandemic on the inflation rate can only be roughly estimated at this point in time.

This is partly due to the comparatively short experience with the pandemic and its economic consequences. Here, the next few weeks and months will show how the rise in the debt ratio, financing by the central banks and the production of the money supply develop.

Well-known examples of inflation

Inflation in Germany until 1923

In 1923, inflation peaked after World War I. People transported mountains of cash for shopping in the supermarket. The background: The First World War drove the Germans out of their wealth. Since there was no money in circulation across the board, the central bank printed more of it. The range of products remained low, however, so that prices continued to skyrocket.

Inflation in Venezuela

The inflation in Venezuela is still dramatic to this day. In 2018, the average inflation rate grew to around 65,000 percent compared to the previous year, according to Statista. Economists even speak of hyperinflation here. The reasons for this lie, among other things, in the mismanagement of the socialist government and the collapse of the oil price. Only recently did the oil state introduce the one million banknote. The current equivalent: around 50 dollar cents.

More:German inflation at its highest level for almost a year - but the value is deceptive