Inflation is an increase in the price of goods and services in a country over time. Usually, it results in the devaluation of the said country’s currency. This is because it diminishes the purchasing power of that currency. After inflation, you would find that you have to spend more on groceries, food, and other household goods.  

A high rate of inflation means that prices are rising fast, while a low rate shows that they are rising slowly. This rate rises when a country’s money supply outweighs its economic growth.

Is inflation all bad?

Usually, a moderate amount of inflation is good as it indicates that a country’s economy is growing. As the economy grows, the demand for goods and services rises, which drives their prices up. Additionally, with a growing economy comes an increased demand for labor, which reduces unemployment and leads to increased wages. The employed populace has more income to spend, which keeps the economy in steady growth.

For this reason, most central banks around the world aim to maintain inflation at a certain level, usually no more than 3%. The US’s Fed and England’s BoE target a level of 2%. If this rate is too high or too low, it can have detrimental effects on the economy. A spike in this rate could cause unemployment, which ultimately leads to slowed economic growth.

Causes of inflation

The root causes of inflation can be divided into two categories — demand-pull and cost-push. The former is seen when consumers have a high disposable income. This means they can afford more goods and services, which drives up the demand for these goods and services. Consequently, this increased demand drives their prices higher.  An expansionary fiscal policy and an expectation of future price hikes can also cause this spike in demand.

Cost-pull inflation, on the other hand, is seen when there’s a diminished supply of goods and services. The shortage forces producers to increase their prices to offset the increased demand. Other factors that can cause this diminished supply are wage increases, changes in currency exchange rates, and a shift in the monetary policy adopted by the central bank.

How to measure inflation

The rate of inflation is obtained from two price index reports. These are the Consumer Price Index (CPI) and the Product Price Index (PPI). The former shows the cost of the most commonly consumed household goods by consumers. PPI measures the cost of the most consumed goods and services by industries, which utilize them to produce more goods and services.

However, CPI is the more commonly used measure of inflation. In the US, the US Bureau of Labor Statistics surveys over 23,000 businesses and 80,000 consumer goods to get a measure of any change in prices. In the UK, the Office for National Statistics is tasked with the same mandate. These prices are then used to obtain the CPI.

Usually, the figure that the Fed uses to calculate CPI excludes food and gas prices. This is because these prices are constantly changing, and their volatility may affect the quality of results obtained. 

UK’s ONS obtains the CPI figure by assigning weights to different goods and services. For instance, housing and related services account for 32% of the CPI, while transport accounts for 11%. Further, the items selected to calculate inflation are changed constantly to reflect the shifting consumer habits. 

Classification of inflation

Inflation is a double-edged sword in the respect that its extremes in either direction can be devastating to the economy. When prices rise rapidly over a short period of time, it is referred to as hyperinflation. This phenomenon occurred in Germany in the 1920s, when monthly rates peaked over 30,000%. More recently, in 2008, Zimbabwe’s inflation reached 79.6 billion percent in November.

Another type of inflation is called stagflation. This is when prices increase steadily with no corresponding economic growth. This means the country is plagued with high unemployment levels while prices keep rising. This phenomenon is rare, but it was recorded in the US and UK in the 70s.

 There’s yet another type called deflation, or negative inflation. This is essentially the opposite of inflation, as it occurs when prices of goods and services drop. Deflation happens when a country’s money supply dwindles, which increases the value of its currency. Consequently, prices drop. It can also be caused by a decreased demand emanating from a spike in supply or a reduction in consumer spending.

How inflation affects the forex market

Basically, the higher a country’s inflation, the weaker its currency becomes. A high inflation rate means that consumer goods are expensive in the country. This drives away most foreign consumers of these goods, thereby reducing exports. A reduction in exports negatively impacts the country’s trade balance, which in turn reduces the demand for its currency. With diminished demand, the currency’s value in the forex market weakens.  

Further, the central bank always takes measures to control inflation in their country. These measures often have an effect on the forex market. When inflation is high, the central bank moves to increase interest rates in a bid to cut down on consumer spending. This increases the demand for that country’s bonds, bringing in foreign investment. Consequently, the demand for the local currency rises, which drives up its value on the forex market.

When inflation decreases, central banks cut interest rates so as to increase the money supply in the economy. This reduces the demand for bonds as they now offer lower yields. This is followed by a reduced demand for the country’s currency, which consequently devalues the currency in the forex market.

Conclusion

Inflation is the increase in the prices of goods and services within a country. A moderate rate is good as it signifies economic growth. High inflation is bearish for a country’s currency. However, when the central bank increases interest rates to curb it, this is usually bullish for that country’s currency. During deflation, central banks move to decrease interest rates, which reduces the value of their currency in the foreign exchange market.

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