Inflation is an economic situation where the general prices of goods and services are going higher over a specific time interval.
Several inflation articles explain the concept of inflation, but the International Monetary Fund defines inflation as “the rate of increase in prices over a given period.” The current inflation rate across the globe is 5.94%. Inflation reports from Europe and the United States show that the rates are dropping after peaking in 2022.
Moderate inflation impacts the economy positively through economic growth, reducing the debt burden and creating jobs. High inflation comes with disadvantages, such as lowering the value of savings, reducing the purchasing power of consumers, and creating income inequalities. Inflation works by depreciating the value of a currency, so it purchases fewer goods and services. Consumers are forced to prioritize their choices because they can no longer afford everything they want.
Forex trading is affected by inflation because it alters the exchange rates and creates market sentiments among traders. Inflation affects the real return of bonds by reducing the bond price and depreciating the value of both the coupon and the yield at maturity.
Inflation affected the major world economies after World War II, during the Korean War, the Gulf War, and after the COVID-19 pandemic.
What is Inflation?
Inflation is the broad increase in the prices of goods and services over a specified period of time. Inflations cause a decrease in the purchasing power of money in an economy or nation over time. Inflation is measured as the periodical percentage increase in the Consumer Price Index (CPI) within an economy or country.
Inflation is the term used to describe the economic situation where the costs of food items, products, and services in an economy are going higher. Inflation is slow when prices gradually rise over time or fast when prices rise rapidly over a short space of time.
Inflation means a general reduction in the value of a national currency. The purchasing power and value of different world currencies have continued to decline with time because of inflation. For instance, according to statista.com, a troy ounce of Gold was sold for an average of $386.20 by the end of 1990, but it was sold for $1,940.50 at the end of 2023.
Forex traders are always on the lookout for inflation figures of currencies because they affect their analysis. For instance, if the JPY loses some value due to inflation, the USD/JPY exchange rate will increase as the USD strengthens against the JPY. Inflation in an economy prompts central banks to take action, which stirs sentiments and expectations among Forex traders. Inflation is a Forex terminology used in fundamental analysis of the strength of a currency.
Inflation in an economy is measured by the Consumer Price Index (CPI). CPI is calculated by creating a basket of goods and services, determining its current value (index), and comparing it with previous periods. Goods and services widely consumed by most households living within the economic zone or country are grouped into a basket. The CPI is derived from aggregating the price of the basket components. The inflation rate is calculated by comparing the CPI for various periods, such as one month, one quarter or one year, and expressing the result as a percentage. There are several inflation formulas, but CPI is the most popular.
Inflation reports across the world indicated a global surge after the COVID-19 pandemic in 2020. Global inflation peaked in 2022 at 9.22%. Inflation in most countries rose to its highest level since the 1980s and 1990s. For instance, in 2022 the USA recorded its worst inflation since 1981, while the Eurozone recorded its highest inflation since 1997.
The post-COVID-19 pandemic inflation was so high because of supply disruptions, higher energy demands, unemployment, climate change, Russo-Ukrainian war, and other factors caused by the pandemic. Inflation rates today have been receding globally since 2023 as the world is recovering from the effects of the COVID-19 recession.
What is the History of Inflation?
The history of inflation dates back to 330 BCE in the empire of Alexander the Great. Inflation recurred in the Roman era around 200-300 CE. Severe inflation was experienced during the French Revolution and American Civil War, and in many other countries at different times.
Inflation was first recorded in history when Alexander the Great (king of Macedonia from 336-323 BCE) conquered Persia and retrieved all silver coins for reforging. Inflation was triggered in the economy when he mixed the silver coins with cheaper metals like copper or lead and produced large quantities of money with lower intrinsic values. The resulting inflation lasted for about 10 years and halved the purchasing power of a silver coin.
Inflation was recorded in the Roman era, when the leaders watered down silver, causing its value to drop. The French Revolution of the 1790s caused inflation, and inflation was rife during the American Civil War of the 1860s.
The post-World War II era recorded high inflation rates. The high inflation was powered by lapses in the supply chain and excessive demand from the United States, which led to 20% inflation in 1947. Inflation peaked at 14.8% in the USA in 1980 during the ‘Great Inflation’ spanning from 1965-1982.
What is the Importance of Inflation in the Economy?
The importance of inflation is that it stimulates the economy by encouraging planning, lending, borrowing, and investing. Inflations lead to the creation of more jobs to boost rising demands. Inflation reduces the value of salaries, making entrepreneurship a viable option.
Inflation supports planning and investments as high potential returns are guaranteed. Investors take advantage of growing economies with moderate inflation to grow their wealth by investing heavily and enjoying high returns. For instance, buying a real estate property will sell for much higher in the future in an economy with moderate or high inflation.
The pressure on businesses imposed by inflation often leads to innovations because businesses are forced to look for avenues to make more profits and beat rising costs. Product innovation leads to new ideas or projects, which can lead to new products and higher potential profits. Process innovation improves productivity, saves time and money, which leads to higher profits.
Inflation encourages strategic partnerships or business alliances formed in order to meet higher demands and rising costs. Business partnerships boost business activities and lead to higher income generation. Partnerships come in the form of marketing campaigns, robust supply chains, automated production processes, or other activities that optimize profits and ultimately lead to business expansion and the creation of more jobs.
Inflation promotes entrepreneurship in an economy by making it more attractive than fixed-income jobs. Entrepreneurs respond to inflation by adjusting the prices of their goods and services to ensure profits, irrespective of the inflation rate. Inflation supports the drive for entrepreneurship by forcing many fixed-income earners to pursue entrepreneurship, which aids economic growth. Entrepreneurship supports job creation, improved productivity, and the overall growth of an economy.
What Causes Inflation?
Inflation in an economy is caused by a higher demand for goods and services than the supply. Inflations occur when the cost of raw materials, commodities, or input goods and services increases. Demand and supply shocks, government monetary policies, climatic and structural factors are capable of causing inflation.
Inflation arises when the number of people who need a product or service exceeds the availability within an economy. For instance, when the demand for a new iPhone is more than the manufacturers or importers can supply, demand-pull inflation occurs.
The high cost of production of a product or service can trigger inflation. For example, when the price of corn increases, the price of corn flour, bread, chicken feed, and other products made from corn rises.
Inflation in an economy is caused by demand and supply shocks or imbalances. For instance, a supply shock may be triggered by natural disasters, pandemics, wars, or geopolitical events.
Monetary policies made by the central bank or government of an economy give rise to inflation. Excess supply of money or devaluation of the currency by the central bank leads to inflation. Inflation is the result of a mismanagement of the economy by the federal government.
Inflation is caused by tax policies, labor laws, urbanization, the aging population, climate change, and a host of other structural factors. The government or central banks are responsible for managing the rate of inflation so that it does not harm the economy.
What Impact does Inflation have?
The impact of inflation is the loss of purchasing power of consumers and businesses. Inflation erodes savings, pension, and investment returns. Moderate inflation has positive impacts, while high inflation has negative impacts on individuals, companies and the economy.
Inflation reduces the value of money in the hands of consumers in an economy. Consumers are unable to buy what they need as the price of goods and services increases over time due to inflation. The economy slows down as a result of little spending, businesses suffer low sales and often resort to retrenchments or total shutdowns.
High inflation discourages individual savings because the value of the saved funds is reduced with time. Inflation reduces the value of returns from investments and pension funds.
Moderate inflation supports economic growth, encourages spending rather than saving, and reduces debt burdens for debtors. Moderate inflation is absorbed by small and large companies without a crisis. For instance, if a company buys raw materials at $10,000 weekly, an inflation of 3% will amount to $10,300. The company absorbs the new cost without borrowing or reducing its staff strength but may slightly increase its product prices to offset the rising costs.
High inflation forces businesses to raise their prices in response to rising costs. Inflation leads to adjustments in the monetary and fiscal policies of an economy. A high inflation rate increases uncertainty, affects the trade balance, and leads to instability in an economy.
How does Inflation Work?
Inflation works by reducing the quantity of goods and services that a defined amount of money can buy with time. Inflations compel sellers to increase prices and charge more for specific goods and services than was previously charged. Consumer Price Index (CPI) and Producer Price Index (PPI) are metrics used by economists to measure the inflation rate in an economy.
Inflation makes consumers pay more for the same goods or services that were previously priced lower. For instance, a laptop that was sold for $500 last year is now sold for $550, representing a 10% price increase.
Merchants and businesses respond to inflation by quickly increasing their prices or charges commensurate with the inflation rate. Sellers continue to raise prices as demand continues in cases where inflation is triggered by scarcity or low supply.
CPI is used to measure the annual inflation or price changes in a fixed basket of popular goods and services. PPI measures the annual changes in the selling prices charged by local producers in an economy. Experts calculate the inflation rate using CPI and PPI indices.
What are the Types of Inflation?
The types of inflation are listed below.
- Demand-pull inflation: Demand-pull inflation occurs when the demand for goods and services exceeds its supply. Consumers are willing to pay more for the same goods and services wherever they are available.
- Cost-push inflation: Cost-push inflation is triggered by the rise in the cost of production of goods and services. Inflation in the price of raw materials, overhead costs and services leads to cost-push inflation.
- Built-in inflation: Built-in inflation arises from expectations from businesses and consumers of continued inflation. For instance, when workers’ salaries are increased, businesses increase their prices in response. The price increase erodes the new wages, and workers demand another increment, which triggers a wage-price spiral cycle and further worsens inflation.
- Stagflation: Stagflation is a combination of high inflation and economic stagnation. High unemployment and slow economic growth characterize stagflation.
- Core inflation: Short-term inflation that does not affect food and energy is known as core inflation.
- Headline inflation: Headline inflation is the total inflation in the economy. Inflations in every sector of the economy are incorporated when estimating the headline inflation.
- Creeping inflation: Low inflation rates of 3% or lower is known as creeping inflation.
- Walking inflation: A yearly inflation rate of 3-10% is described as walking inflation.
- Galloping inflation: An inflation rate of more than 10-50% in a year is galloping inflation.
- Hyperinflation: Monthly or yearly Inflation rates of 50% or higher is referred to as hyperinflation. For instance, in Zimbabwe, the hyperinflation peaked at 79.6 billion percent in November 2008, and in Venezuela, it reached 2.6 million percent in January 2019.
How does Inflation Impact the Economy?
Inflation impacts the economy positively through economic growth, job creation, and the reduction of debt burdens. Inflations negatively affect economies by creating uncertainty, reducing purchasing power, eroding savings, and creating income inequality. Inflation affects exchange rates, interest rates, fiscal policies, and the GDP of economies.
Low inflation encourages spending, lending, and borrowing, which are drivers of economic growth. A growing economy supports the creation of more jobs, higher wages, business investments, and expansions.
High inflation impacts low-income consumers negatively because most of their income will only be able to afford essential needs such as rent, energy, and food. Governments or central banks respond to high inflation by increasing interest rates. High interest rates discourage borrowing, encourage savings, and reduce overall spending in an economy. Inflation declines with reduced spending and more savings.
Other effects of inflation on the economy are listed below.
- Inflation reduces the value of growth stocks and bonds.
- Inflation decreases the debt burden.
- Inflation impacts the performance of various sectors of the economy, such as manufacturing, agricultural productivity, technology, tourism, and finance.
- Inflation creates uncertainty among investors and businesses where inflation is very high.
- Inflation widens income inequalities.
- Inflation erodes savings, especially long-term savings like pension funds.
- Inflation depreciates the value of a currency and its exchange rates.
What is the current inflation rate? The current inflation rate is 5.94% globally. The global inflation rate rose to 4.7% in 2021 after the COVID-19 pandemic, according to Statista.com. Inflation hit 8.73% in 2022 and 6.78% in 2023. The International Monetary Fund (IMF) expects the global inflation rate to drop to 5.8% in 2024. The US inflation rate was 4.12% in 2023 but it is currently at 2.4% (September 2024).
Why are the Prices going up due to Inflation?
Prices are going up due to inflation because there are a lot of willing buyers contending to purchase few available goods and services. Sellers increase prices due to inflation because they must cover the increased cost of sales or cost of production and also add their profits.
Merchants consider the cost price, transportation costs, and all other overhead costs when fixing product prices. Inflation leads to price increment when any of the associated costs incurred in the production or purchasing process increase.
Production delays arising from shortages of raw materials cause a price increase. Dealers respond by increasing the price of goods in their custody as restocking is temporarily unavailable. For instance, car factories need various components from different parts of the world, and production delays due to the unavailability of some parts lead to higher car prices.
Supply disruptions or logistics setbacks cause inflation. For instance, in February-March 2022, the Russo-Ukrainian war adversely disrupted global supply chains of crude oil and natural gas from Russia to Europe, forcing prices to soar.
Who Benefits from Inflation?
Borrowers that are servicing fixed-interest loans, exporters and big businesses with pricing power, real asset investors, and governments when they owe large domestic or foreign debts benefit from inflation.
Inflation benefits individuals who already have existing fixed-interest loans because they will pay back with less valuable money. For instance, sudden inflation will not affect the monthly payments made on an existing fixed-rate mortgage. The monthly payments remain the same even if the debtor’s income increases because of adjustment to inflation.
Businesses and local producers that have control over their prices capitalize on inflation to improve their profit margins. Companies that produce essential goods with huge customer bases cite rising costs as a reason, then increase their product prices beyond the margin of inflation.
Banks and big lenders benefit from inflation because it causes a higher demand for credit facilities. High demand raises interest rates, which translates to greater profits.
Inflation benefits owners of real assets like land, buildings, precious metals, and artworks. Real assets have inherent values and are known to serve as a hedge against inflation and for the preservation of wealth. Inflation causes an increase in the value of real assets.
Governments benefit from inflation because it reduces the debt burden. Inflation reduces the value of the nominal bonds issued by a government and the interest paid on the bonds. External debts owed by the government are impacted by inflation, making them less valuable and easier to repay.
Why is Inflation bad?
Inflation is bad when it becomes too high in an economy because it leads to economic instability, income inequality, and devaluation of the domestic currency. Inflations become bad when they result in economic stagnation or recessions. Poverty, hardship, and crime rates increase in economies with very high inflation rates.
High inflation reduces the purchasing power of the currency in an economy, which leads to lower standards of living. Low-class citizens drop to the very poor as they struggle to pay for essential goods and services. Retrenchments and unemployment increase because businesses struggle to meet rising costs. The economic situation degenerates into higher crime rates as a result of inflation.
Inflation worsens income inequality in an economy. High-income earners thrive while low-income earners suffer. High-income earners have multiple sources of income, such as real assets or rental properties whose value and income appreciate during inflation.
Investors and businesses struggle with indecision and uncertainty in an economy plagued with high inflation. Unemployment rates become high as businesses shut down their operations when they can no longer cope with rising costs. High inflation over long periods slows down the economy and leads to recession.
Who Suffers most from Inflation?
Fixed-income earners and pensioners suffer most from inflation because the value of their income is reduced. Savings account owners suffer from inflation as their long-term savings are now worth less. Bondholders suffer losses from inflation as fixed-rate bonds depreciate in value.
Inflation hits hardest on poor and low-income households with fixed incomes. Inflation forces salary earners to adjust their budgets to focus more on necessities because their income can no longer afford luxury. Pensioners are affected with the same problem of low income and high expenses occasioned by inflation.
Savers suffer from inflation, especially if the money is saved as cash in a safe box. Inflation depreciates the purchasing power of the money in a safe or bank account.
Investors who hold bonds issued by governments or companies suffer losses as inflation reduces the value of their invested funds and interests.
Can Shares Act as a Hedge Against Inflation?
Yes, shares can serve as a hedge against inflation. Investments in the shares of staple companies over long periods have proven to be a good hedge against inflation. The values of company shares grow with time, and some companies pay dividends from time to time.
A share is a financial security that represents a unit of company equity or ownership. Inflation can be beaten by investing in staple company shares that pay higher returns than interest rates. Staple companies are businesses that produce or sell essential goods and services that are in high demand.
Top-performing companies’ stocks that have high growth rates or pay dividends act as a good hedge against inflation. For instance, Apple (NASDAQ: AAPL) has been paying dividends to shareholders 4 times a year since 2012. Apple Inc.’s share has grown tremendously over the years, and investors are enjoying good returns, which have grown above inflation.
Investments in stocks are not guaranteed, according to shares definition, but a carefully chosen, diversified portfolio stands a good chance of hedging against inflation. A financial advisor is important if you are not very conversant with stock investing.
Does Inflation Rise when Recession Happens?
No, inflation does not usually rise during most recession periods, but it happens once in a while. Stagflation is the rare occurrence where inflation happens during a recession. Natural disasters, monetary policies, and supply disruption are some of the factors that cause stagflation.
Recession is characterized by reduced spending and less demand for goods and services. High inflation is capable of triggering a recession, while a recession slows down inflation.
Stagflation is often engendered by sudden shocks or unfavorable events such as wars or natural disasters. Supply disruptions or shortages of raw materials and essential goods can trigger stagflation in an economy.
How does Inflation Affect Forex Trading?
Inflation affects Forex trading by weakening the currency of the economy affected. The exchange rates of the currency pairs involving the weak currency go up or down in response to inflation. Forex traders adjust their strategies as they monitor inflation rates, interest rates, monetary policies, and other fundamental data that affect the Forex market.
A weakened currency from an economy under inflation gives Forex traders insights about the direction of the exchange rate. For instance, if the Australian economy is affected by high inflation, the EUR/AUD exchange rate will go up because more AUD will be needed to buy 1 EUR. The exchange rate of AUD/USD will depreciate because AUD is the base currency, and less USD will be exchanged for more of the weak AUD.
Central banks are responsible for managing exchange rates and inflation through adjustments to money policies. Forex traders collate data on inflation rates and other related data and incorporate them into their trading strategies. Traders speculate on the response of central banks to inflation and how traders will respond in the Forex market.
How do Forex Traders Handle Inflation?
Forex traders handle inflation by constantly monitoring the inflation figures in comparison with their trading strategies. Forex traders move to safe-haven currencies in times of high inflation. Diversification to commodities as an inflation hedge is one of the options available in times of inflation.
Forex traders constantly monitor the inflation rates and predict the market sentiments. Forex traders and analysts predict central banks’ interest rate adjustments to check inflation and arrive at a consensus. Forex traders hone their strategies and wait for official interest rate releases while others jump into the markets before the release.
Currencies from stable economies that are known to withstand economic downturns and difficult times are often referred to as ‘safe-haven’ currencies. Forex traders handle inflation by trading safe-haven currencies and avoiding currencies from economies under inflation. Flight to safe-haven currencies is a popular method of handling high inflation by Forex traders.
Forex traders have the option of hedging against inflation through diversification. Gold and other commodities are popular investments used to hedge against inflation. Diversification of investment portfolios is a risk management strategy that Forex traders use to handle inflation and other risks associated with Forex trading.
How does Inflation Impact the Forex market?
Inflation impacts the Forex market by reducing the values of the currencies and their exchange rates. Inflations lead to adjustments in monetary policies, affecting exchange rates and impacting the Forex market. Forex market participants respond according to available fundamental data, which results in volatility or stability in the market.
High inflation weakens the value of a currency. Currencies are paired and traded against each other in the Forex market, with the major currencies paired with several other currencies. A weak major currency, especially USD, will affect multiple exchange rates in the market. For instance, a weak USD will affect the exchange rates of EUR/USD, GPB/USD, USD/JPY, AUD/USD, and a host of other currency pairs involving the USD.
High inflation forces foreign investors and businesses out of an economy or country. The exit of investors causes a decline in the demand for its currency. The value and exchange rates of the currency depreciate in the Forex market.
Forex market investors monitor inflation rates, interest rates, and statements from key players in the economy. Rising inflation evokes investor sentiments in the Forex trading market as traders respond according to their strategies. Investor sentiments lead to uncertainty or volatility in the market.
Do Forex brokers provide inflation news for traders?
Yes, Forex brokers provide inflation news for traders through the economic calendar, daily market news and analysis, newsletters, and newsfeeds on trading platforms. Forex brokers form partnerships with Forex news portals, financial research firms, and industry experts to provide inflation news and other services to traders.
Forex brokers provide inflation news and other trading news to traders through the economic calendar, which can be accessed on their websites or trading platforms. An economic calendar is a global calendar that shows the dates, times, and impacts of economic news and events that are known to affect the Forex market. Analysts’ prediction, impact assessment, impact history, and charts are some of the features of the economic calendar. Forex traders use data from the economic calendar provided by Forex brokers for their fundamental analysis and trading.
Forex brokers that do not have the in-house capacity or resources to provide inflation news or analysis form partnerships or outsource these services to expert Forex research firms. For instance, brokers provide traders access to portals powered by FXStreet, TradingCentral, or Claws & Horns.
How does Inflation Impact the Real Returns of Bonds?
Inflation impacts the real returns of bonds by decreasing the value of the bond yield. Inflations erode the purchasing power of the fixed coupon rates as well as the face value paid at maturity. Bond price depreciates when interest rates go up as a result of inflation.
Bonds are debt securities issued by the government or corporate organizations to raise funds for its operations. Bonds are fixed-rate investments that pay periodic interests to investors until maturity, when the full principal is paid back to the investor. A bondholder has lent money to the issuer which will be paid back in full at maturity, but the investor will receive fixed-rate interest payments until maturity, as per the bonds definition.
Inflation negatively affects the total returns accrued from long-term bonds. For instance, a 4% corporate bond with a face value of $1,000 and 10 years of maturity pays $40 yearly until maturity, when the bondholder gets his $1,000 back. Inflation in the economy reduces the purchasing power of the $40 as the years roll.
Existing bonds are bought and sold in the secondary bond market while new bonds are issued by the government or corporate organizations. Inflation reduces the value of old bonds when they are finally paid at maturity. Bonds with longer maturity times are at higher risks of inflation eroding their returns. Inflation presents bondholders with two unfavorable choices, either to sell off the bond in the secondary bond market at a lesser amount or to hold on to maturity and be paid the bond’s face value.
Inflation is the major reason why central banks raise interest rates. Bond values are inversely proportional to interest rates. The value of an existing bond depreciates when the interest rates go up because the old bonds become unattractive. New bonds, with higher interest rates, become available while old bonds lose value as a result of inflation.
What are Examples of Inflation?
Some inflation examples are listed below.
- World War II: Inflation was experienced during and after world war II (July 1946 – 1948). Supply shortages, high demand, and lack of price control spiked inflation to over 20%.
- The Korean War: High demand from households and less production fueled inflation during and after the war (Dec. 1950 – Dec. 1951)
- Oil Crisis inflation: Inflation was experienced in the United States and parts of Europe for 9 years (April 1973 – October 1982). The Inflation was a result of spikes in oil prices caused by an embargo from OPEC and oil shortages occasioned by the Iran – Iraq war.
- Gulf War: Inflation occurred when Iraq invaded Kuwait. Uncertainty caused a rise in the price of crude oil, triggering inflation from April 1989 to May 1991.
- 2008 Global inflation: The 2008 global inflation was caused by high food and fuel prices, according to the IMF. Some countries responded by setting prices and paying subsidies to cushion the effect of inflation, while others could not.
- Venezuela’s inflation: Venezuela experienced hyperinflation from 2013 to 2021. By 2018, the inflation peaked at 1.7 million percent, with shortages in food and medical supplies. The inflation was triggered by political instability, declining oil revenues, and unfavorable government policies.
- Post-pandemic inflation: The global post-COVID-19 pandemic inflation (2021 – 2023) has been attributed to supply chain disruptions, monetary policies, the Russian-Ukraine war, and the aftermath of the COVID-19 pandemic.
What are the Advantages of Inflation?
The advantages of inflation are listed below.
- Debt burden relief: Inflation depreciates the value of borrowed funds. Debtors find it easier to pay back. For instance, the value of a mortgage declines so homeowners can pay up faster.
- Real estate appreciation: Real property values appreciate in times of inflation.
- Pricing power advantage: Businesses that have the capacity to increase prices without sacrificing patronage use inflation periods to increase prices and make more profits.
- Stock appreciation: Public companies increase prices and make more profits during inflations. Higher profits mean higher dividend amounts and company share appreciation.
- Middle-class benefits: Inflation helps the middle class to grow their wealth. Net worth improves with appreciated assets, increased incomes and reduced debt values.
- Economic growth: Moderate inflation can lead to higher production, higher wages and more spending which stimulates economic growth.
What are the Disadvantages of Inflation?
The disadvantages of inflation are listed below.
- Savings lose value: Retirement savers and anyone saving money for projects are hurt by inflation as the savings amount depreciates.
- Reduced purchasing power: Consumers only buy less of what they can buy in the past which forces the poor and low-income earners to adjust their spending.
- Fixed income depreciation: Inflations cause fixed-income investments to lose value.
- Government intervention: Tax increments, removal of subsidies, and interest rate hikes are ways the government intervenes to curb inflation.
- Little or no savings: Inflation makes it difficult to save money. Consumers spend most of their income on essentials with little or nothing to save for the future.
Can Central Banks Control Inflation?
Yes, central banks can control inflation by coming up with policies that impede inflation and slow down the economy until inflation goes back to acceptable levels. Interest rate adjustments are the most popular tools used by central banks to control inflation.
Central banks stipulate tolerable rates of inflation accepted in their economy. For instance, the Federal Reserve, Bank of Japan, Bank of England, and European Central Bank have all set targets of a 2% inflation rate. The South African Reserve Bank’s inflation target is 3-6%, Russia’s central bank targets 8-8.5%, while the People’s Bank of China sets 3%. Central banks respond accordingly when inflation crosses acceptable thresholds.
Central banks increase interest rates to discourage borrowing and spending when inflation is high. Disinflation occurs when interest rates are increased. Disinflation means a decrease in the rate of inflation. Interest rates are reduced by central banks when inflation drops back to preset margins.
Central banks can control inflation by Quantitative tightening, which involves selling securities to reduce the money supply in the economy. Forward guidance is a strategy used by central banks to manage inflation by signaling future policies. For instance, releasing statements or documents indicating high interest rates sustenance will slow down inflation.
What are the Differences between Inflation and Deflation?
The differences between inflation and deflation are listed below.
- Inflation is the general increase in prices of goods and services, while deflation is a period marked by declining prices of goods and services.
- Inflation is marked by reduced currency value, while deflation is characterized by currency value appreciation.
- Moderate inflation stimulates economic growth, but deflation slows down the economy.
- Inflation reduces the burden of debtors, while deflation increases the debt burden.
- Inflation is caused by high demand, supply disruptions, and excess cash in the economy. Deflation is caused by increased supply, technological advancements and an overall decrease in money flow.
Inflation and deflation are both economic conditions that describe the price movements of goods and services in an economy over time. The deflation vs inflation relationship is the opposite.