On news websites, when you click on the business section, you might find updates on the level of inflation. But what is it and how does it affect me?
Inflation is the change in the overall price level. It is usually positive. An annual inflation rate of 2% means that, on average, something that cost $100 a year ago, costs $102 now. Of course, this is an average. Some prices might remain unchanged while others might increase by much more.
WHY DO PRICES CHANGE?
There are two main reasons why prices change. The first is called “demand pull.” This inflation happens because there is high demand for goods and services in the economy. If more people want to buy a phone this year, companies can charge a higher price while consumers compete for who can buy it.
A small amount of demand-pull inflation in the economy is normally seen as a good thing because it shows that people are wanting to buy the products that are being offered. If no-one wants to buy the products so the price is falling, this suggests that products are low quality or unpopular. Some demand-pull inflation should be expected in Sub-Saharan Africa as incomes are increasing. This means that there are more consumers who want to buy products.
The other type of inflation is called “cost-push” inflation. This occurs when the costs of production increase. For example, the cost of raw materials and labour might be increasing without the company being able to produce any more of the good. This is normally seen as a worse kind of inflation because it shows a lower rate of productivity.
This is normally the kind of inflation when food prices are suddenly increasing. This shows that it has been a difficult harvest, so the output has fallen even though the cost of running the farm has stayed the same.
HOW DOES INFLATION AFFECT ME?
If everything is getting more expensive quicker, this affects your purchasing power. The same amount of money can buy you fewer goods and services since everything is getting more expensive.
This particularly affects people whose incomes are fixed or people saving money. If you are earning more because more people are demanding your goods, so you make more profit, then inflation does not affect you as much. Prices are increasing but so is your income. If your wealth is fixed and prices are increasing, you cannot buy as much with your wealth.
Policy-makers usually target a low and stable inflation rate. This has several benefits. First, as mentioned before, it prevents a large loss of purchasing power for people on fixed incomes.
Second, if inflation is stable, people will start expecting the same inflation rate in the future. If the price of everything was suddenly very high and there was no stable inflation rate, business owners would increase their prices too so that they increase profit to deal with these higher prices. Workers might ask for higher wages. This leads to an even bigger increase in inflation as costs of production and prices go up. If inflation is not managed carefully by policy-makers, this leads to hyper-inflation, where inflation is extremely high, such as in Zimbabwe in 2008/09. Keeping inflation low and steady stops it spiralling out of control so there is more certainty in the economy.
Inflation is an important part of the economy and the inflation rate has large consequences for businesses and consumers. Policy-makers should aim to manage inflation as they manage economic indicators like GDP growth.