The ABCs of inflation: everything you need to know

September 2024, by Mario Pires

Inflation is a term that has become part of our daily lives in recent years, but do we know what we really mean when we talk about inflation?

What is inflation after all?

Inflation is all about changing prices. Prices are subject to change: some go up, others go down. When there is a generalized, permanent and sustained increase in the prices of goods and services, this is an example of inflation. 

How can we measure inflation?

Inflation is measured using a consumer price index. This calculation is based on price changes. This is done by assessing the cost of a set of essential products, such as food, clothing, transport and energy, and tracking the variation in their value over time. Governments usually calculate official consumer inflation statistics. 
However, there are other ways of measuring inflation. Producer price inflation, for example, tracks the prices that manufacturers pay for the raw materials needed to make their products. Housing and energy prices also have their own methodology.

What causes inflation?

There are two main types of inflation that help to understand how prices can rise in an economy:

• Cost pressure (or so-called cost-push inflation): when the production costs of goods and services increase, consumers face an increase in the prices of final products. For example, if the price of oil rises, transportation and production costs also rise, leading to a general increase in product prices.
• Demand stimulus (or so-called demand pull): prices can also rise when demand for certain goods and services exceeds the supply available on the market. For example, during festive seasons when there is a greater demand for certain products, the prices of that product may rise due to the high demand.

Inflation is currently being driven primarily by cost pressures. Energy is a component in most goods and services, and when the price rises, producers have to reflect these adjustments in costs.

What is “core” inflation?

Underlying inflation, also known as core inflation (core inflation), is a measure that seeks to identify long-term trends in price movements, excluding the impacts of temporary or volatile factors such as energy and unprocessed food prices.
By excluding these items, it gives a clearer picture of underlying price trends. Core items include essential goods, such as education, telecommunications and health care costs, or non-essential goods, such as restaurant meals and entertainment.
Without careful economic management, we run the risk of seeing successive increases in wages and the prices of essential items, which could result in destabilizing “wage price spirals”. In this case, inflation expectations become a self-fulfilling prophecy. Prices rise – or become “unanchored” – as a result.

Why is excessive inflation seen as a problem? Who suffers the most from this problem?

The most obvious danger of inflation is that if prices rise faster than incomes, people may buy fewer goods and services, resulting in a drop in living standards.
In practice, the negative effects of inflation are more subtle, affecting different groups in different ways and having a broader destabilizing effect on societies. For example, it is more difficult for those on fixed incomes, such as pensioners; it can reduce the value of a currency against other currencies, making imports more expensive; as future costs are difficult to plan for, it can dissuade companies from investing; or it can lead workers to demand higher wages, creating a “wage-price spiral” of additional inflation.