Inflation: What It Is and How to Contol It

Inflation is a phenomenon characterized by a general increase in the prices of goods and services throughout an economy over time. This has profound effects on both individual consumers and businesses. Let’s look at the reasons behind inflation and its consequences.

Inflation for consumers

For regular consumers, inflation can serve two functions:

Indicator of diminishing purchasing power. Inflation reduces the buying power of money. The value of the currency decreases, meaning it takes more money to buy the same amount of goods and services as before. A moderate rate of inflation can actually encourage spending, drive demand, and enhance productivity during periods of economic downturn.

Indicator of economic health. A stable economy typically sees annual inflation rates of around two percent, which is generally considered a sign of stable pricing. If inflation rates begin to exceed wage growth, it can serve as a warning sign of an economy in distress.

Inflation for businesses

Inflation affects businesses as well resulting in:

Loss of purchasing power. As the costs of inputs such as raw materials and intermediate goods rise, businesses lose purchasing power.

Compression of profit margins. The increased costs of production can lead to shrinking profit margins, prompting businesses to raise their prices to maintain profitability. But they must be cautious not to dampen consumer demand.

How to determine inflation levels?

Statistical organizations measure inflation by analyzing the current value of a collection of goods and services that households consume (known as a price index). They calculate inflation rates by comparing the value of the index over different time frames – like monthly or annually).

In the US, the Consumer Price Index (CPI) is utilized to monitor the spending habits of urban households on a wide array of items. The representative basket contains typical items bought by Americans, including food, energy, durables (like vehicles and clothing), and services (such as housing and medical care). Each item’s significance is determined by its contribution to total expenditures, and the weights are applied accordingly.

Learn more about the Consumer Price Index and core CPI in our article.

How to control inflation?

In the US, inflation is controlled by the Federal Reserve (the Fed) which serves as the central bank of the United States.

The Fed’s goal is to maintain long-term inflation at approximately 2%. To do so, they are enhancing employment, adjusting interest rates, and preserving price stability. By altering the amount of money circulating in the economy, the Fed can influence inflation indirectly. The Fed can adjust interest rates four times a year.

In times of economic crisis (such as the Great Recession or the COVID-19 pandemic), the Fed engages in asset trading with the Treasury Department’s backing. These assets are held by US banks (e.g., bonds or other securities).

As of January 2022, the U.S. witnessed an inflation rate of 7.5%, the highest since 1982, propelled by factors such as rising energy costs, labor imbalances, and supply chain disruptions. Since then, the US government has been fighting the issue.

In essence, gauging inflation entails observing price fluctuations over time. Controlling it necessitates the Fed’s tactical changes to interest rates and quantitative easing.

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