Understand the mechanism of inflation in a few minutes?

November 1, 2022 by Louis DETALLE

Understand the mechanism of inflation in a few minutes?

In this article, Louis DETALLE (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2023) explains everything you have to know about inflation.

What is inflation and how can it make us poorer?

In a liberal economy, the prices of goods and services consumed vary over time. In France, for example, when the price of wheat rises, the price of wheat flour rises and so the price of a loaf of bread may also rises as a consequence of the rise in the price of the raw materials used for its production… This small example is only designed to make the evolution of prices concrete for one good only. It helps us understand what happens when the increase in price happens not only for a loaf of bread, but for all the goods of an economy.

Inflation is when prices rise overall, not just the prices of a few goods and services. When this is the case, over time, each unit of money buys fewer and fewer products. In other words, inflation gradually erodes the value of money (purchasing power).

If we take the example of a loaf of bread which costs €1 in year X, while the price of the 20g of wheat flour contained in a loaf is 20 cents. In year X+1, if the 20g of wheat flour now costs 22 cents, i.e., a 10% increase over one year, the price of the loaf of bread will have to reflect this increase, otherwise the baker will be the only one to suffer the increase in the price of his raw material. The price of a loaf of bread will then be €1.02.

We can see that here, with one euro, i.e., the same amount of the same currency, from one year to the next, it is not possible for us to buy a loaf of bread because it costs €1.02 and not €1 anymore.

This is a very schematic way of understanding the mechanism of inflation and how it destroys the purchasing power of consumers in an economy.

How is the inflation computed and what does a x% inflation mean?

In France, Insee (Institut national de la statistique et des études économiques in French) is responsible for calculating inflation. It obtains it by comparing the price of a basket of goods and services each month. The content of this basket is updated once a year to reflect household consumption patterns as closely as possible. In detail, the statistics office uses the distribution of consumer expenditure by item as assessed in the national accounts, and then weights each product in proportion to its weight in household consumption expenditure.

What is important to understand is that Insee calculates the price of an overall household expenditure basket and evaluates the variation of its price over time.

When inflation is announced at X%, this means that the overall value spent in the year by a household will increase by X%.

However, if the price of goods increases but wages remain the same, then purchasing power deteriorates, and this is why low-income households are the most affected by the rise in the price of everyday goods. Indeed, low-income households can’t easily cope with a 10% increase in price of their daily products, whereas the middle & upper classes can better deal with such a situation.

What can we do to reduce inflation?

It is the regulators who control inflation through major macroeconomic levers. It is therefore central banks and governments that can act and they do so in various ways (as an example, we use the context of the War in Ukraine in 2022):

They raise interest rates: when inflation is too high, central banks raise interest rates to slow down the economy and bring inflation down. This is what the European Central Bank (ECB) has just done because of the economic consequences of the War in Ukraine. The economic sanctions have seen the price of energy commodities soar, which has pushed up inflation.

Blocking certain prices: This is what the French government is still doing on energy prices. Thus, in France, the increase in gas and electricity tariffs will be limited to 15% for households, compared to a freeze on gas prices and an increase limited to 4% for electricity in 2022. Without this “tariff shield”, the French would have had to endure an increase of 120%.

Distribute one-off aid: These measures are often considered too costly and can involve an increase in salaries.

Bear in mind that “miracle” methods do not exist, otherwise inflation would never be a subject discussed in the media. However, these three methods are the most used by governments and central banks but only time will tell us whether they succeed.

Figure 1. Inflation in France.

Source: Insee / Les Echos.

Useful resources

Inflation rates across the World

Insee’s forecast of the French inflation rate

About the author

The article was written in October 2022 by Louis DETALLE (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2023).

The return of inflation

August 2, 2021 by Alexandre VERLET

The return of inflation

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explains how inflation could become an issue again for the first time in 40 years.

Inflation is not something we usually worry about. In fact, few understand what inflation is about beyond the fact that it is characterized by a rise in prices. But since inflation has been around for 40 years without causing any problem, it seems to be absolutely not dangerous and perfectly controlled by central banks. Problem is, the Covid-19 crisis and the economics policies launched by governments and central banks in response are unprecedented. Moreover, an excess of inflation can be a major problem for developed economies: the UK in the 1970’s was Europe’s sick man and had to revolutionize its economy the hard way in order to get out of its stagflation spiral.

So why are we talking about a 40 year old subject? Because for several weeks now, markets have been worried about a sustained return of inflation. Fantasy for some, harsh reality for others: the scenario of a sustainable return of inflation is far from unanimous among economists. None of them, however, disputes the appearance of signals favorable to an at least temporary rise in prices, even if the extent of the phenomenon is debated. Indeed, the latest figures from the United States speak for themselves: in April, prices there rose by 4.2% over one year. This is the first time since September 2008 that the markets have been particularly nervous in recent days. In the euro zone, inflation, although more moderate (+1.6% year-on-year), also seems to be accelerating as economies are recovering from the crisis.

What is inflation and what is causing it to return?

To put it simply, inflation is the sustained rise of general prices over a period of time. It is calculated using a basket of products in which their weight in the GDP is taken into account so the basket represents the economy as a whole. The causes of inflation can be derived from a simple phenomenon: the imbalance between supply and demand of good. In our case, all the ingredients were in place for a rise in prices. Initially, the end of the Covid-19 epidemic in China and the roll-out of the vaccination campaign, particularly in the United States, contributed to the sudden rebound in global demand. But the supply side was not able to keep up with the movement and meet all the needs, since supply chains and production processes are still disorganized. Adding to that, some countries remain closed, and global supply chains cannot be restarted overnight after more than a year of pause. As a result, bottlenecks have developed in some sectors and manufacturers are now facing shortages of raw materials. Companies must also adapt their production processes under the Covid-19 regulation, and all this has a cost.This automatically leads to higher production costs, which companies pass on in their prices.

Beyond the tensions on the goods and services market, other signals are worrying the markets across the Atlantic. Starting with Joe Biden’s three stimulus plans, which will involve almost 30% of US GDP. These massive plans, which are flourishing both in the United States and in Europe, are encouraged by the central banks’ accommodating policy and their unlimited power of money creation which, through asset purchases, allow governments to go into debt at lower cost. But by injecting so much money to stimulate demand, the Fed and the White House are taking the risk of putting the US economy in a state of overheating which could lead to a surge in prices in the US and, by contagion, in Europe. This is the principle of the quantitative theory of money developed by the economist Milton Friedman in 1970 when he stated that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be generated only by an increase in the quantity of money faster than the increase in output. The other phenomenon fueling fears of a sustained acceleration in prices is the tightness in the US labor market. Some sectors are facing a shortage of labor, including low-skilled workers, which could restart the “wage-price loop”. Several companies, including McDonald’s and Amazon, have already announced a significant increase in their minimum wage and attractive hiring bonuses to attract new candidates to the United States.

How would the return of the inflation impact us?

If it does not exceed a certain level, inflation is not necessarily harmful to the economy and can even be good for some. Keep in mind that the European Central Bank is aiming for an inflation rate close to but below 2% per year. The markets fear the return of inflation, but everyone is waiting for this inflation. Since 2008, the world entered a phase of low inflation but also of risk of deflation. While rising prices cause consumers to lose purchasing power in the short term, they often result in higher wages in the medium term. Not least because the French minimum wage is indexed to inflation, as are a number of social benefits. And an increase in the minimum wage most often results in an increase in the lowest wages, as explained by INSEE in a study on wages in France. In addition, employee representatives usually use inflation as a reason to obtain wage increases during annual negotiations in the company. If the employer accepts an increase at least equal to that of prices, then the purchasing power of employees remains stable. But one of the main winners from an acceleration of inflation is the state. When prices rise across the board, tax revenues increase. Another positive consequence is that inflation increases the capacity to repay public debt, since it increases nominal GDP and thus reduces the debt/GDP ratio. The same mechanism applies to all borrowers. At least if wages keep pace with inflation over time. Let us take the case of an employee earning 2000 euros per month. This person has taken out a fixed-rate loan with a monthly payment of 500 euros. Let us also assume an inflation rate of 2% for three consecutive years. Assuming that wages increase at the same rate, the employee will receive 2122 euros per month three years later but will still have to continue to repay 800 euros. His debt ratio would then fall from 32% to 30%. It would then be easier for him to repay his loan. The opposite is true for savers. When inflation is higher than the rate of return on savings, which is the case for the Livret A, the real return becomes negative. This means that the capital invested loses value. Finally, civil servants or pensioners can also be the big losers of a return of inflation if their income is not revalued in line with inflation, as has been the case in recent years. Provided that it is not excessive, inflation is not always a bad thing and is even often synonymous with growth. The question is therefore to know how much inflation will be and whether it will be sustainable.

In the current context, the prospect of uncontrolled inflation cannot be ruled out. The pre-existing equilibrium was not one of non-existent inflation, but one of well-anchored inflation expectations. The extremely accommodating fiscal and monetary policies are now threatening that balance.

If private agents start to doubt the willingness and ability of their central bank to defend price stability, then expectations may be derailed and a return to normal inflation would require huge sacrifices. To prevent expectations from deteriorating further, the central bank would be forced to absorb liquidity by a reverse quantitative easing, which would cause a rise in long-term rates and a contraction in economic activity. As a consequence, the ability of States to take on debt would become severely limited, which would threaten the sustainability of post-covid recovery plans.

Should we worry about the future because of inflation?

The inflation threat should be definitely be treated seriously by central banks. Nevertheless, the scenario of an uncontrolled inflation remains unlikely, especially in Europe where the stimulus package were far from the size of Biden’s plan. Firstly, the rise in prices in the United States is largely temporary. The shortage of raw materials and labor will eventually fade, so the resulting inflation should do the same. Secondly, the inflation figures observed in April should be put into perspective as they reflect a catch-up phenomenon. Indeed, demand had fallen at the same time last year due to the confinement, which had also pushed prices down. It should also be noted that the increase in prices in the US is highly sectorised: one third of the monthly inflation in April was linked to the evolution of second-hand car prices. And if we exclude volatile prices such as energy and food, US inflation reached 3% over one year. For their part, central banks such as the US Fed point out that a number of deflationary elements have not disappeared, starting with unemployment, which puts the risk of wage inflation into perspective. If inflation anticipations are still strong enough to offset those two trends, central banks will have to raise key rates to cool the economy in order to limit price increases. It would then be the end of the years of “free money”, and that is something that will impact all of us as potential borrowers. So keep an eye on economic indicators over the next few months!

About the author

Article written in August 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).

Inflation and the economic crisis of the 1970s and 1980s

July 31, 2021 by Alexandre VERLET

Inflation and the economic crisis of the 1970s and 1980s

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) goes back on the inflation issue of 1970’s/1980’s and the lessons it teaches us for the 2020’s.

In the developed capitalist countries, the fight against inflation became the top priority of economic policy in the 1970s. Georges Pompidou’s famous formula: “better inflation than unemployment” was buried for good. Inflation can be defined as the continuous and self-sustaining rise in the general price level. It is the result of a monetary struggle conducted by the various economic agents to maintain or increase their income or their capital: it has winners and losers. For economic decision-makers, inflation is a “sweet poison”: on the one hand, it is a factor of growth (by stimulating investment and consumption, and at the same time favoring production and employment); on the other hand, it is a danger for this same growth if the rise in prices gets out of hand (trade deficit, capital flight, ruin of savers). By what mechanisms does the inflationary growth of the 1960s give way to the rapid stagflation of 1973-1986?

Low inflationary growth was at the heart of the virtuous circle of the Trente Glorieuses

The Second World War and the post-war period were times of great inflationary pressure due to the large-scale expenditure by governments to finance the war effort, economic reconstruction and the establishment of the welfare state. France struggled with the problems of currency and price stability. Germany had the lowest inflation of the OECD countries since the monetary reform of 1948 and the priority given to a strong currency. Some countries, such as France, had chronic inflation. The debate raged in the years 1945-1952: a man like Mendès-France resigned from the government in 1945 to protest against monetary and budgetary laxity, stating that “distributing money to everyone without taking it from anyone is to maintain a mirage… “(extract from his letter of resignation, June 6, 1945). The growth of the 1950s and 1960s was generally not very inflationary in the developed countries: the Bretton Woods agreements ratified the stability of exchange rates around the dollar, the only reference currency convertible into gold. However, it was not until 1958 that European currencies regained their convertibility. Wartime periods remained inflationary: the Korean War (1950-53), for example, during which there was a rise in the price of raw materials, an increase in public spending in the United States and an increase in the circulation of dollars. From the beginning of the 1950s, once reconstruction had been completed, to the beginning of the 1960s, inflation fluctuated between 1 and 4% per year in the industrial countries. Moreover, Keynesian economic policies aimed to stimulate demand through deficit spending, which created inflation, and then to contain the pressure of demand when tensions were too great, so that inflation was limited. The alternation of stimulus (inflation) and austerity (deflation) took the form of the stop-and-go policy that characterized Great Britain and the United States in the 1950s. Consequently, in a period of full employment, a certain amount of “natural” unemployment is accepted in order to avoid too much pressure on wages and therefore on prices, as demonstrated by the British economist A.W. Philllips (Economica Journal, 1958). Inflation is in this perspective a lesser evil: it is seen as a painless way of financing growth: in fact, it works in favor of companies that go into debt, it has a favorable effect on their financial profitability. In a country such as France, it makes it possible to arbitrate social conflicts by defusing profit/wage tensions (the government negotiates both wage increases and low-cost credit).

The 1960s: the “inflationary spiral” begins to get out of control

From 1961-62 onwards, the developed industrial countries experienced an acceleration in price increases: a significant and lasting rise in inflation, from 3 to 5% until the early 1970s. During this period, there was no significant reduction in unemployment and even a slight increase in the number of job seekers: is this the end of the jobless era? In any case, the Phillips curve seemed to apply more and more poorly to the economic situation. There are several causes for this. Firstly, the growing importance of budget deficits: due to the use of deficit spending in the Keynesian logic; due to the implementation of the welfare state and social programs: for example, in the United States, the New Frontier programs of J.F. Kennedy and the Great Society of L. Johnson. Secondly, the deterioration of the international monetary system: devaluation of the pound sterling, crisis of the dollar at the end of the 1960s. Lastly, the wage increases outstripped productivity gains, which were slowing down: the “crisis of Fordism”: in other words, inflation through wage costs.

The 1973 and 1979 oil shocks

As seen previously, the 1970’s inflation is a consequence of economic phenomena already observed in the 1960’s. However, the two oil shocks were game changers. This time we are talking about cost inflation: the cost of energy supply is at stake, with the price of a barrel of oil multiplying by more than 11 in 1973 and 1979. This explains why inflation continues even when demand is lacking, when there is stagflation and part of the production capacity is unused. During classical crises, overproduction results in a general fall in the price level and a collapse of production, as shown by the Great Depression of the 1930s. On the contrary, during the crisis of the 1970s, prices rose continuously after the two oil shocks of 1973 and 1979, while production was very unstable (after a collapse in 1973-1974, it picked up again in 1975-1976). Inflation was now high: from an average of around 5% per year in the early 1970s, it rose to double-digit figures between 1973 and 1975, and again between 1979 and 1982.

The economic consequences of inflation

The crisis is industrial and commercial: companies’ profits collapse because of rising costs; their international competitiveness is severely damaged because of the relative rise in prices. The crisis is social: the unemployment curve follows that of inflation, but without showing any real inflection between 1973 and 1982: it calls into question the Phillips curve analysis, as there is a simultaneous rise in unemployment and inflation. The number of unemployed in the OECD rose from 10.1 million in 1970 to almost 33 million in 1983, which roughly corresponds to a tripling. European countries seem to be particularly affected: unemployment has multiplied by almost 4 in the same period. The crisis is also financial. On a national scale, part of the population is ruined by rapid inflation (savers, rentiers, farmers, employees), while another part makes significant gains (speculators). On an international scale, the debt of Third World countries literally exploded: from 130 billion dollars in 1973 to more than 660 billion dollars in 1983. Currencies tend to depreciate, which causes a generalized rise in prices: galloping inflation becomes global (Mexico for example). What’s more, Keynesian policies further reinforced the symptoms that had been combated, and were strongly criticized by the monetarist movement. Double-digit inflation makes Keynesian anti-crisis policies ineffective. For example, with an inflation rate of 13.5% in 1980 in France, the inflationary policy of President F. Mitterrand had disastrous effects on the competitiveness of French firms: it wiped out their margins, caused them to lose market share and finally penalized foreign trade. The fight against inflation became the main objective of monetarist policies. For Mr. Friedman, it is necessary to return to Phillips’ interpretation: it applies in a transitory way in the history of capitalism, when economic agents cannot predict or anticipate the rate of inflation. It is no longer a question of explaining inflation by the state of the labor market, but the opposite: it is the inflation anticipated by consumers that explains the tensions on the labor market; he shows that Keynesian recipes increase inflation through money creation without any effect on employment (because consumers anticipate it, consume less, which translates into a reduction in employment among producers). More inflation leads to more unemployment and, in an open economy, a decrease in the competitiveness of companies. The 1970’s crisis sheds light on how inflation works and to what extent the Phillips curve model can be applied to real-world situations. This useful to remember in a time when inflation is coming back for the first time in thirty years.

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021).

Inflation Rate

April 27, 2021 by Bijal GANDHI

Inflation Rate

In this article, Bijal GANDHI (ESSEC Business School, Master in Management, 2019-2022) explains in detail about the inflation Rate.

This read will help you understand the causes for inflation, the pros and cons of inflation and finally how to control inflation.

What is inflation?

Inflation in simple terms means an increase in the cost of living. It is basically an economic term which means that an individual must spend more money now than before to buy the same goods or services. The percentage increase in the prices over a specified period can be termed as the inflation rate. As the prices increase, the purchasing power of each unit of the currency decreases. The change in the price level of a well-diversified basket of goods and services can help estimate the decline in the purchasing power. This basket should include commodities, services, utilities, and everything else that humans need to lead a comfortable life. Therefore, the calculation of inflation is a complex process. It is measured in several ways depending upon the goods and services included in the calculation.

Deflation is the opposite of inflation and it indicates a general decrease in the prices of goods and services. It occurs when the inflation rate is lesser than 0%.

Types of inflation

Inflation rates can be divided into the following categories depending upon their characteristics,

Creeping inflation means that the prices have increased by 3% or less during a year.
Walking inflation refers to an increase in prices between 3-10% a year. It is destructive in nature and is harmful for the economy.
Galloping inflation causes an absolute havoc in the economy as the prices rise by 10% or more.
Hyperinflation is a rare phenomenon which occurs when the prices rise by 50% or more.

What are the three causes of inflation?

The rise in prices is most associated with the rise in demand. But there are several other mechanisms that result in an increase in the money supply of an economy. These mechanisms can be classified into the following three types,

Demand-pull effect

The demand-pull effect refers to the situation in which the demand exceeds the supply for goods and services. This may occur due to an increase in the money supply and credit, stimulating the overall demand. The consumers are willing and able to pay higher prices for a product thereby leading to a price rise.

Cost-Push Effect

A cost-push effect occurs when the supply is restricted while the demand is not. The supply could be restricted due to several factors like the scarcity of raw materials, the increase in the prices of production inputs, pandemics, etc. These additional costs may result in a higher cost for the finished product or reduce supply. In any case, the prices would rise resulting in inflation.

Built-in Inflation

The built-in inflation is a result of the cause-effect relationship. It is based on the people’s expectations of inflation in the coming years. The laborers and workers will demand a higher wage if they expect that the prices of goods and services will rise. Thereby increasing the cost of production. This will further result in an increase of the prices of goods and services again.

Measure of inflation

The Consumer Price Index (CPI) evaluates the change in the average price of a selected basket of goods and services over time. This predetermined basket mainly includes necessities like food, medical care, and transportation. The change in price of each component is calculated over a period and averaged to its relative weight in the basket. It is a widely used measure for both the inflation and effectiveness of the government’s policy. In the US, the CPI reports are published on a monthly and yearly basis by the U.S. Bureau of Labor Statistics. The value of inflation can be calculated over a period between two dates using the following methodology:

Formula for inflation

If you wish to know the purchasing power of a certain sum of money from one period to another, you can input data in this Inflation Calculator by the U.S. Bureau of Labor Statistics and see the results. This calculator uses the same methodology and CPI data as mentioned above.

Is inflation good or bad?

Inflation can be either good or bad depending upon the situation of individuals. For example, individuals holding cash or bonds would not like inflation as the purchasing power of their holdings would decrease. Individuals with investments in assets like real estate, commodities, etc. would appreciate inflation as the real value of their holdings will increase.

Central banks often struggle in maintaining an optimal level of inflation. Spending is encouraged over saving as increased spending will help boost economic activities. This is because it would be profitable for individuals to spend now instead of later if the purchasing power of money is expected to fall. For example, in the U.S., the Federal Reserve aims for a target rate of inflation of 2% YoY. A very high inflation rate can have catastrophic consequences. For example, Venezuela, which was suffering from hyperinflation (1087%) in 2017, collapsed into a situation of extreme poverty and uncertainty. Individuals who depend upon savings or fixed income are affected the most. This is because the interest rates in their savings accounts in the banks are lesser than the inflation rate, thereby making them poorer. Similarly, lower-income families are highly affected if the rise in their wages does not keep up with the rise in the prices. A high inflation also pressurizes governments to take actions to financially support the citizens as the cost-of-living increases.

Bijal Gandhi

Similarly, a deflation situation is not healthy as well. Consumers may put off spending as they may expect a fall in the prices. The reduced demand for goods and services will result in slow economic growth. This could further result in a recession-like situation with increased unemployment and poverty.

How to control inflation?

As discussed in the Interest rates post, the financial regulators of a country shoulder the responsibility of maintaining a stable and steady inflation rate. In the US, the Federal Reserve communicates inflation targets well in advance to keep a steady long-term inflation rate. This is because price stability helps businesses plan well ahead in future and know what to expect. The central banks through the monetary policy actions controls the money supply. For example, they adopt methods like quantitative easing to either counter deflation or to maintain the targeted inflation rate.

One powerful way for individuals would be to increase their earnings either through demanding a higher pay or promotions to keep up with inflation. Other options include investing in the stock market. Stocks are a good way to hedge against inflation. This is because a rise in the stock price will be inclusive of the effects of inflation. Another alternative would be to invest in instruments indexed to the inflation. Treasury Inflation Protected Securities (TIPS) and Series I Bonds are examples of such instruments.

Useful resources

U.S. Bureau of Labor Statistics

Investopedia Inflation Rate

The Balance How to measure Inflation

About the author

Article written in April 2021 by Bijal GANDHI (ESSEC Business School, Master in Management, 2019-2022). Bijal has two years of experience in the financial markets and is currently working as a financial analyst at Mega Biopharma.