Inflation rate or Consume Price Index (CPI) is the rate at which the average current prices of consumer goods and services rise from a base year which can be several years ago. The base year is set a value of 100. The average of aggregate consumer price of a basket which contains a selected list of goods and services may increase or decrease each month, quarter or year. At the end of the measuring period CPI calculated as to get a percent of change.
When CPI increases, people can purchase only fewer goods or services compared to the past period for the same amount they hold. They enjoy consuming more when inflation rate lowers.
The factors that affect consumer price changes are:
Money supply: Total volume of money in circulation by public abbreviated as M1, M2, etc. M1 includes most liquid money such as cash, while M2 include assets such as CDs which can be converted to cash. M3 is a much broader money supply form. Inflation can rise when money supply increases.
Systemic and non-systemic events: Systemic events such as major health crisis, national and international major events, wars, droughts or non-systemic events such as technological advancements that reduces employment, etc., can affect the demand and supply of goods/services. When demand is lower, price of goods/services can go lower. However, recent records show that prices are sticky because, due mergers and acquisitions, the monopolistic tendency have increased amoung suppliers. They have larger cash reserves to hold back from reducing the prices despite lower demand. Smaller companies are quickly responsive to economic conditions they run their business in and may decide not to lower prices.
When recessionary conditions are withdrawn, or when there is high employment and/or rise in wages, the demand may rise. The prices may also rise when there is high demand during a period of supply constraints.
Interest rate changes: One of the monetary policy to contain inflation is to increase the interest rates that funds new investments. This has an automatic effect on the demand for goods/services, thereby hoping a price reduction at the cost of economic development.
Fiscal policies such as tax rates changes: Another inflation containment approach is increasing various tax rates. Direct and indirect taxes such as income tax, sales and excise taxes and import tariffs can suppress inflationary effect by reducing demand for good and services, while also reducing economic expansion.
The central banks all over the world prefer to maintain a low inflation to maintain a health economy. According to most economists, maintaining approximately 2% inflation rate reduces the chances of recession. A positive 2% inflation buffer provide policy makers reasonable time to adjust the factors that are affecting the economy before the country fall into recession.
Rising inflation can be readily handled by raising taxes on income, tariffs, or similar measure. However since any tax increase can only be established by political establishments, US and many developed countries prefer their central banks increasing the interest rates to slow down the inflation.
The chart below displays the current and our predicted inflationary growth rates for the USA. We also show how much prices have risen or fallen after major incidents that affected the economy of US. From the triangular step lines, you can see how much inflationary effects are sticky and permanent after post COVID induced supply-constraints in 2020s.
Related concepts of inflation are:
Core inflation
Deflation
Disinflation
Stagflation
Hyperinflation
Reflation
Asset price inflation
Agflation
GDP Deflator