What Is Inflation, and How Does It Affect the Purchasing Power of Money?

In recent months, the term inflation has been mentioned more and more frequently on television, radio and the internet. However, many economic subjects do not really know what inflation is, how and what’s causing it, or how it can be measured. The following blog will guide you through everything essential to know about inflation, including how we can protect ourselves from it.

What Is Inflation?

Inflation can be described as a reduction in the purchasing power of money over time. In practice, however, it doesn’t mean that a paper banknote or coin changes the numerical value stamped on it. Inflation is manifested by the growth of the price level in the economy, i.e. the growth of the prices of individual goods and services.

Inflation causes what the majority of the population complains about in the current challenging economic situation – that for the same amount of money, you can afford fewer goods than, for example, a year ago.

As a currency loses its purchasing power, the same amount of money in the economy buys fewer and fewer goods and services because the population’s current expenditures rise. Thus they can afford to spend less and less. A decrease in household consumption ultimately leads to a slowdown in economic growth. The inflation rate is normally reported as a year-on-year change in percentage. For example, if you have €50,000 in your account and inflation in the country is 10%, the next year, the real purchasing power of your money will be only €45,000.

Causes of Inflation

Although the issue of inflation is very complex and complicated, there are several basic causes of its occurrence.

The main and most common cause is the increasing amount of money in circulation. This is done through expansionary monetary policy, through which central banks issue new and cheap cash into circulation, usually to promote and sustain economic growth over the long term. Expansionary monetary policy is most often implemented through:

• Decreasing interest rates – Decreasing the prime interest rate causes money to become inherently cheaper. Commercial banks respond to a drop in the base rate by lowering interest rates on mortgages and loans, making money more accessible to ordinary residents. At the same time, the reduction of interest rates stimulates the population’s consumption.

• Quantitative Easing – Quantitative Easing is one of the monetary tools of central banks through which the central bank buys various assets (stocks, bonds or other securities) from the government or from other commercial banks in exchange for cash. However, this new money used to buy assets is not backed by anything, which means that it is an emission of money practically “out of nothing”.

Furthermore, there are several other causes of inflation, based on which we divide inflation into the following two categories:

• Demand-pull inflation 
• Cost-push inflation 
• Built-in inflation

Source: Intuit

Demand-Pull Inflation

Demand-pull inflation occurs when the economy’s total demand for goods and services is higher than the production (output) of the given economy. From the relationship between supply and demand, if the demand for goods and services exceeds their supply, it is usually reflected in the rise in prices.

To make it easier, let’s imagine it on a model example. In a small town with a population of 8,000, the local dairy can produce 500 litres of milk per day. The dairy manages to sell all the milk it produces every day, so everything works as it should. At the beginning of the summer, however, a new private residential district will open in the town and up to 2,000 new residents will move into the town.

With the increase in the population, there is also a natural increase in the demand for milk. However, dairy already produces the maximum daily amount of milk and cannot increase its production capacity any further. The dairy could build a new milk processing hall and buy more cattle, but this will take time.

Until then, however, there are many more people interested in the milk than there is an actual supply. Some residents will be willing to pay more to get milk. This means that dairy will naturally increase the price of milk.

However, other cheese, butter and yoghurt producers also take milk from this dairy. The increased price of milk will also be reflected in the increase in the prices of other products.

Cost-Push Inflation  

Cost-push inflation arises due to the increase in the prices of inputs needed for the production or distribution of various goods and services. If the prices of inputs necessary for production rise, the increased expenses for businesses will be reflected in the selling price of products to the final consumer.

We can use the previous model to understand cost-push inflation. A dairy that produces 500 litres of milk a day for a small town operates practically without problems and sells all the milk it produces each day.

However, under the influence of the war in the neighbouring country and the influence of the poor harvest, the dairies’ electricity and feed expenses will increase, which means that milk production will be subject to higher production costs. The increased cost of milk production is thus reflected in the sales price for consumers.

Built-In Inflation

Built-in inflation is a type of inflation directly related to the expectations of employees who think the current inflation rate will persist. If there is an increase in the prices of goods and services, employees expect similar price increases in future periods and therefore demand an equivalent increase in wages to maintain their standard of living.

The increase in wages for employees, however, results in increased input costs for businesses, which will then be reflected only in a renewed increase in the prices of goods and services – which creates a spiral effect. However, built-in inflation does not arise by itself; it is usually significantly influenced by demand-pull and cost-push inflation.

Measuring Inflation

Inflation can be measured depending on how wide a range of goods and services are included in the index intended to measure inflation. In practice, the following are used most often to measure inflation:

Consumer Price Index (CPI)

The CPI index is most often used in practice to measure inflation. From January 2022, the development of the consumer price index is determined on a universal consumption basket consisting of 738 goods and services, divided into twelve divisions of the COICOP classification (Classification of Individual Consumption by Purpose) and which make up a significant part of the total expenditure of the population. Individual divisions are distinguished from each other not only by the number of monitored products in the division but also by weights. Although the CPI index does not provide such comprehensive data as, for example, the GDP deflator, it is possible to measure more precisely the effects of inflation on consumers on a monthly basis.

Example: The structure of the consumer basket in Slovakia looks as follows: 

COICOP division	The title of the COICOP division	Constant weight per mille	Number of representative items
	Consumer price index	1,000.000	738
	Of which:
01	Food and soft drinks	206.1105	146
02	Alcoholic beverages and tobacco	53.5839	13
03	Clothing and footwear	47.9086	87
04	Housing, water, electricity, gas and other fuels	268.1212	50
05	Equipment, household equipment and routine maintenance of the house	74.0901	90
06	Health	28.0780	37
07	Transportation	63.2909	85
08	Communications	37.1565	21
09	Recreation and culture	75.4162	84
10	Education	14.2974	8
11	Hotels, cafes and restaurants	58.2403	45
12	Various goods and services	73.7058	72

Source: Statistical Office of the Slovak Republic

The GDP Deflator

The GDP deflator is considered the most comprehensive price index through which inflation can be measured. Unlike the CPI index, the deflator is not made up of a consumer basket of selected goods and services but considers price changes of all goods in the economy. Inflation is usually only measured quarterly using the deflator, while it is more precise to use the CPI index or the Industrial Producer Price Index to determine the impact of inflation on consumers or producers. However, the GDP deflator trends are usually similar to trends measured by the CPI.

Harmonized Index of Consumer Prices (HICP)

The Harmonized Index of Consumer Prices (HICP) was created based on the requirements of the European Council to compare inflation between the countries of the European Union and the Eurozone. Through this index, it is possible to monitor the change in prices and goods between member countries of the union and the eurozone. Individual countries use the same methodology for measuring inflation, meaning that inflation in one country can be effectively compared with inflation in another.

Inflation, as measured by the CPI in the United States, has reached its highest level in 40 years.

Source: Bureau of Labor Statistics

How to fight inflation?

In situations where inflation is out of control, it is necessary to introduce strict and especially effective measures to prevent further depreciation of money. Central banks in countries around the world use the following measures to deal with inflation:

• Increasing interest rates – By increasing basic interest rates, central banks achieve the effect of making money more expensive and less available. Commercial banks also react to the increase in the base rate as they borrow “more expensive” money from central banks, which is reflected in interest rates on loans and mortgages. Thus, loans become less attractive to consumers, which, on the other hand, can be reflected in a decrease in consumption and demand for goods and services. When interest rates increase, interest in savings or term deposits grows because the rates on these products tend to rise.
  

• Quantitative tightening – This is the opposite of quantitative easing. During quantitative tightening, the balance sheet of central banks is reduced. Therefore, parts of the assets purchased during quantitative easing are sold off.
  

• Adjustment of fiscal policy – One of the alternatives, which, however, is often met with opposition from the population. It can include, for example, an increase in income tax.

How to protect against inflation? 

Money that you leave lying idle in your bank account or under your pillow at home loses its purchasing power under the influence of inflation. The most effective way to protect your funds from inflation is investing.

However, investing is a very general term. Investing involves the ability to put your money into different asset classes, which are usually differentiated by the level of risk involved. It is important to note that if an investor wants to invest effectively, it is important that his return is higher than the rate of inflation. However, in the current situation, when inflation is hitting double-digit values, it is not easy to find assets that can generate double-digit returns on investments.

According to many experts, the best protection against inflation is gold or various alternative investments – wine, oil, real estate or cryptocurrencies.

Due to its limited supply, gold has historically proven to be an effective tool for preserving value over time. The strongest cryptocurrency Bitcoin has similar properties, but unlike gold, it has a precisely known finite amount in circulation. Additionally, Bitcoin can be traded 24/7, while traditional gold can only be traded on business days.

The essential combination of these two products is an effective anti-inflationary instrument called Fumbi Bitcoin and Gold, which combines on the one hand the long-term stability of real gold and the huge technological and growth potential of Bitcoin. In the past year, this product has achieved a performance of up to 34%, which has perfectly protected our users’ funds from inflation.

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