“Perception is real, even when it is not reality” ~ Edward de Bono
Inflation refers to a sustained rise in the overall level of prices in an economy. Economists use various price indices to measure the overall price level, also called the aggregate price level.
The inflation Rate is the percentage change in a price index—that is, the speed of overall price level movements. Investors follow the inflation rate closely, not only because it can help to infer the state of the economy but also because an unexpected change may result in a change in monetary policy, which in turn have a large and immediate impact on asset (including stock market) prices. In developing countries, very high inflation rates can lead to social unrest or even shifts of political power. This constitutes political risk for investments in those economies.
Central banks, the monetary authority in most economies, monitor the domestic inflation rates closely when conducting monetary policy. Monetary policy determines interest rates and the available quantities of money and loans in an economy. A high inflation rate combined with fast economic growth and low unemployment usually indicates the economy is overheating, which may trigger some policy movements to cool it down. However, if a high inflation rate is combined with a high level of unemployment and a slowdown of the economy, it produces an economic state known as stagflation (for stagnation plus inflation). In this case, the economy will typically be left to correct itself because no short-term economic policy is thought to be effective.
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Inflation means that the same amount of money can purchase less real goods or services in the future. So, the value of money or the purchasing power of money decreases in an inflationary environment. Hyperinflation usually occurs when large scale government spending is not backed by real tax revenue and the monetary authority accommodates government spending by increasing the money supply.
“Life will find its way” ― Michael Crichton, Jurassic Park
Hyperinflation may also be caused by the shortage of supply created during or after a war, economic regime transition, or prolonged economic distress of an economy caused by political instability. During hyperinflation, people are eager to change their cash into real goods because prices are rising very fast. As a result, money changes hands at extremely high frequency. The government also has to print more money to support its increased spending. As more cash chases a limited supply of goods and services, the rate of price increases accelerates.
After World War I, a famous case of hyperinflation occurred in Germany from 1923 to 1924. During the peak of this episode, prices doubled every 3.7 days. After World War II, Hungary experienced a severe hyperinflation during which prices doubled every 15.6 hours at its peak in 1946. In 1993, the inflation rate in Ukraine peaked at 10,155% per year. In January 1994, the monthly inflation rate peaked at 313 million percent in Yugoslavia. The most recent hyperinflation in Zimbabwe reached a peak of monthly inflation at 79.6 billion percent in the middle of November 2008. Because the basic cause for hyperinflation is too much money in circulation, regaining control of the money supply is the key to ending hyperinflation.
In layman term, inflation is “too many money chasing after too few goods.”
After reading this, you’ll probably wonder about:
- What are the possible assumptions and biases in their estimation?
- If you can trust the computation in central banks?
We’ll take you there. In our next article on Inflation Rate, we’ll take a dive into the Construction of Price Indices by the central banks.
Share with us on your thoughts and questions below, and we’ll get back to you!
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