What is inflation and what causes it?

What is inflation and what causes it?

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A concept familiar to almost every Zimbabwean is inflation, and to any student that has gone through an introductory economics course, is the Zimbabwean 2008 inflation case study. Yet again Zimbabwe is in their second destructive inflationary period in the same number of 21st century decades. Zimbabwe has all but adopted and claimed inflation as its long lost child. This problem child has been responsible for the undermining of many livelihoods. But just what is inflation? How does it affect consumers and businesses? And what causes it?


Inflation measures the rate at which the overall goods and services price level in an economy is rising. The inflation rate quantifies this increase over a given period of time. A month on month inflation rate measures the rate at which the price level increased or decreased from one month to the next, whilst the annual inflation rate measures the percentage change over the year. Inflation is commonly measured using the Consumer Price Index (CPI), in which the price level of a basket of goods and services reflecting the average basket purchased by households for consumption is tracked regularly. It assesses the following components: Food and non-alcoholic beverages, Alcoholic beverages and tobacco, clothing and footwear, Housing water electricity gas and other fuels, Furniture, household equipment, and maintenance, Health, Transport, Communication, Recreation and culture, Education, Restaurants and hotels, and Miscellaneous goods and services. To calculate the CPI a weighted geometric mean of these components is calculated. However, some economists argue that CPI is not a good measure of inflation, as the basket of goods and services consumed differs from person to person and the rate and extent of price fluctuation differ with components. Others believe that the inclusion of food and energy in the calculation distorts the CPI calculation due to their volatile nature, whilst the rest do not think this is a valid reason to exclude key components from the calculation. Another problem is that the calculation does not account for the change in the quality of goods and services over the period.


There are different classifications of inflation, namely deflation, disinflation, and hyperinflation. Deflation refers to the general decrease in the price level of goods and services in an economy, whereas disinflation is the decrease in the inflation rate from period to period, i.e. disinflation is the decrease of the inflation rate from 10% to 9%. Hyperinflation refers to high rampant inflation rates, typically month on month inflation rates of higher than 50%. 


Amidst these various forms of inflation, it's no wonder that 41% of small business owners identify inflation as their primary concern, given its potential impact on their operations and profitability.


If allowed to become rampant, the hard-earned money of consumers loses purchasing power, giving rise to the saying, “A dollar today is worth more than a dollar tomorrow”. For a person earning a certain amount, the basket of goods and services the salary can afford gets smaller with time in the presence of inflation. Inflation is a major problem for pensioners earning a fixed pension, as the value of their pension fund can be eroded by inflation leaving them without a source of subsistence. It has a tendency to cause people to spend what they have in an attempt to maximise the value of their money whilst dissuading saving, as people realise that the savings they have will not be worth much in the future. For businesses, inflation comes with higher expenses, as the cost of key production goods rises, and employees demand higher wages. So what causes inflation?


Inflation is mainly a result of 2 things, demand related items and supply related items. The first occurs when the aggregate demand grows too quickly that it outgrows aggregate supply, and is called demand-pull inflation. Due to the excess demand for goods and services in short supply, companies raise their prices to match the increased value in the scarce resource. Demand-pull inflation can be due to a depreciating local currency, higher government spending, and a fall in interest rates. Another form of inflation is the cost-push inflation which occurs when the price of raw materials increase and companies are forced to increase prices to avoid making a loss. Costs may rise due to the lack of skilled workers, which would require business to offer unsustainable salaries to attract and retain them. It can also be caused by the global increase in prices of vital raw materials, the expectations of price increases by the general population, depreciating local currency and the desire of larger profits by large dominating companies, usually monopolies. In the case of Zimbabwe in 2008, the inflation was caused by the Reserve Bank printing more money than there was a demand for.


Nyasha Mukechi is a Consultant at Industrial Psychology Consultants (Pvt.) Ltd a management and human resources consulting firm.

Phone +263 4 481946-48/481950 or cell number +263 773274381 or email: nyasham@ipcconsultants.com or visit our website at www.ipcconsultants.com

Nyasha Mukechi
This article was written by Nyasha a Guest at Industrial Psychology Consultants (Pvt) Ltd

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