The mystery of Inflation | Basics
Econoville’s Guide to Understanding Inflation
Hello, 👋
The value of money we hold is always decreasing. To either maintain or increase its value we have to invest it somewhere which can give us more or equal appreciation. If I have earned some money, I should have all the rights to hold it but if people start holding money than it seems the whole economic system will start failing.
The circulation of money is essential for economic growth. And this circulation is ensured by healthy inflation. Now, with the story of professor penny and town of Econoville, let’s understand inflation. Enjoy!
Garvit Sahdev enjoys understanding ideas that shape our world. The Thoughtful Tangle is an initiative to share this journey and experience with his friends who love to do the same. He selects one idea and dives deep into it to understand its basics, relevance, impact and opportunities around it. The thoughtful tangle is special because 👇
📝 One long article per idea. We call it ‘The Basics’.
📝 Multiple unique insights. Separate small articles for special ‘Insights’.
🧑🤝🧑 Experts perspective. Check out ‘Insiders’
Once upon a time in a small town called Econoville, people lived their everyday lives, buying and selling goods and services. They used a currency called the "EcoDollar" for their transactions. Life was good, and people were happy because they could buy what they needed with the money they earned.
One day, the town's wise old economist, Professor Penny, gathered everyone in the town square to explain a concept that was becoming more noticeable in their daily lives: inflation.
"Inflation," Professor Penny began, "is like a sneaky little force that makes the prices of things you buy go up over time. It’s as if the EcoDollars in your pockets are losing some of their power to buy things. So, if a loaf of bread costs 1 EcoDollar today, in the future, it might cost 1.10 EcoDollars or even more."
The townsfolk were puzzled. "Why does this happen?" they asked.
Professor Penny smiled and said, "Inflation is the result of many factors, like when more money is circulating in our town, or when the cost of producing goods goes up. It’s usually measured over a year and expressed as a percentage. For example, if the price level in our town rises by 2% in a year, that’s called inflation."
The townsfolk nodded, starting to understand. But then one of them asked, "Are there different kinds of inflation?"
"Yes," Professor Penny replied, "inflation comes in different forms, depending on how fast prices are rising."
She continued:
Creeping Inflation: "This is a gentle rise in prices, about 1-3% each year. It’s like a slow-moving stream, easy to handle and doesn’t cause much trouble. Most people don’t even notice it."
Walking Inflation: "This is a bit faster, with prices rising between 3-10% annually. It’s like a brisk walk, where you start to feel the effects more noticeably. People begin to worry because their money isn’t going as far as it used to."
Galloping Inflation: "Now, this is when things start to get out of hand, with prices increasing by 10-50% every year. It’s like a galloping horse, hard to keep up with, and it makes life very challenging for everyone."
Hyperinflation: "This is the most extreme form, where prices skyrocket by more than 50% every month. It’s like a runaway train, out of control, and can cause a lot of harm to the economy. People start to lose faith in the currency itself."
The townsfolk were amazed by these different types of inflation. "But how do we measure inflation?" someone asked.
Professor Penny explained, "We have a few tools to measure inflation, like checking the temperature of our economy."
Consumer Price Index (CPI): "Imagine a basket filled with goods and services that people in our town usually buy, like food, clothes, and housing. The CPI measures how the total cost of this basket changes over time. If the cost goes up, it means inflation is happening."
Producer Price Index (PPI): "This is like checking the prices that producers, like farmers or factories, are getting for their products. If their prices go up, it often means that the prices we pay as consumers will go up too."
Wholesale Price Index (WPI): "Similar to PPI, this index measures the price of goods at the wholesale level before they reach the final consumer. It’s another way to keep track of inflation."
GDP Deflator: "This is a broader measure that looks at the overall price changes of all goods and services produced in our town. It helps us see how much of the growth in our economy is due to rising prices rather than increased production."
As Professor Penny finished, the people of Econoville felt enlightened. They now understood that inflation was a natural part of their economy but something that needed to be kept in check. With their new knowledge, they felt more prepared to manage their finances and make wise decisions in the future.
And so, life in Econoville continued, with everyone keeping a watchful eye on the prices around them, knowing that understanding inflation was key to maintaining a healthy economy.
Professor Penny, always eager to share her wisdom, decided to explain the causes of inflation so that the townsfolk could better grasp why prices sometimes went up.
Gathering everyone in the town square once again, she began, "Now that you know what inflation is, let’s talk about why it happens. There are three main causes: demand-pull inflation, cost-push inflation, and built-in inflation."
The townsfolk leaned in, eager to learn more.
Demand-Pull Inflation
"Demand-pull inflation," Professor Penny explained, "happens when there’s too much money chasing too few goods. Imagine if suddenly everyone in Econoville had more EcoDollars to spend. What do you think would happen?"
One of the townsfolk replied, "People would want to buy more things, but if there aren’t enough goods available, the prices would go up!"
"Exactly," Professor Penny said with a smile. "This type of inflation can be caused by several factors:
Increase in Money Supply: "If the town’s treasury prints more EcoDollars and releases them into the economy, people have more money to spend, which can drive up prices."
Increased Government Spending: "If the town’s council decides to spend more on public projects, it can lead to more money circulating in the economy, raising demand for goods and services."
Lowering of Interest Rates: "If the town’s bank lowers interest rates, it becomes cheaper for people to borrow money. They might take out loans to buy more things, increasing demand and pushing prices higher."
Positive Consumer Expectations: "If people feel optimistic about the future, they might spend more today, thinking that prices will only go up. This increased spending can also drive prices higher."
Cost-Push Inflation
"Now," Professor Penny continued, "let’s talk about cost-push inflation. This type of inflation happens when the cost of producing goods and services goes up, and businesses pass those higher costs on to consumers in the form of higher prices."
She gave some examples:
Rising Raw Material Costs: "If the price of raw materials, like oil or metal, goes up, it becomes more expensive for businesses to produce their goods. They might raise their prices to cover these costs."
Wage Increases: "If workers demand higher wages and businesses agree to pay them, the cost of production rises. Companies might increase prices to maintain their profits."
Natural Disasters Affecting Supply: "If a natural disaster, like a storm or drought, damages crops or disrupts supply chains, the reduced supply of goods can lead to higher prices."
Monopoly Power of Companies: "If a company has a lot of control over the market, it can raise prices without worrying too much about losing customers, especially if there are few alternatives available."
Built-In Inflation
"Finally," said Professor Penny, "there’s something called built-in inflation. This happens when people expect prices to keep rising, and their behavior actually helps make it happen."
The townsfolk looked puzzled, so she explained further:
Expectation of Future Inflation: "If people think prices will go up in the future, they might start buying more now, which increases demand and pushes prices up."
Price/Wage Spiral: "Sometimes, workers demand higher wages because they expect prices to rise. If businesses then raise prices to cover those higher wages, it creates a cycle where both wages and prices keep going up."
Indexation of Wages: "In some cases, wages are automatically adjusted based on inflation. This means that if prices go up, wages also go up, which can keep the cycle of inflation going."
By the end of the lesson, the people of Econoville felt they had a much clearer understanding of why inflation happened. They realized that it wasn’t just one thing that caused prices to rise, but a combination of different factors. With this knowledge, they felt more prepared to navigate the ups and downs of their economy.
And so, life in Econoville continued, with the townsfolk better equipped to understand and respond to the forces of inflation, ensuring that their beloved town thrived for years to come.
The town of Econoville had become well-versed in the causes of inflation, thanks to Professor Penny’s teachings. However, the wise professor knew there was more to the story. She wanted the townsfolk to understand not just why inflation happened, but also how it affected their lives in different ways.
One sunny afternoon, she gathered the people once again in the town square. "Today," she began, "we’re going to talk about the effects of inflation. You see, inflation doesn’t just make things more expensive—it has a wide range of impacts on our economy, society, and even our politics."
The townsfolk listened closely as she began to explain.
Economic Impacts
"First," Professor Penny said, "let’s talk about how inflation affects our economy. When prices rise, it doesn’t just mean you pay more for your daily needs. It creates a ripple effect throughout our entire economic system."
Reduced Purchasing Power: "As inflation increases, the EcoDollars in your pocket buy less than they used to. This is called reduced purchasing power. It means that even though you might be earning the same amount, you can’t buy as much with it."
Uncertainty in Business Planning: "For businesses, inflation makes it hard to plan for the future. If prices keep changing, it’s difficult to know how much to charge customers, how much to pay employees, or even how much to invest in new projects. This uncertainty can slow down economic growth."
Impact on Savings and Investments: "Inflation also affects your savings. If the interest you earn on your savings is lower than the rate of inflation, your money is actually losing value over time. It can also make investing tricky, as people try to find ways to protect their money from losing value."
Effects on International Trade and Exchange Rates: "Inflation can impact our trade with other towns or countries. If our prices rise faster than those in other places, our goods become more expensive for others to buy, and they might choose to trade elsewhere. This can also affect exchange rates, making our EcoDollars worth less when exchanged for other currencies."
Social Impacts
"Inflation doesn’t just affect our wallets," Professor Penny continued. "It can also have serious social consequences."
Income Redistribution: "Inflation doesn’t affect everyone equally. Some people might be able to raise their prices or wages to keep up, while others cannot. This can lead to a redistribution of income, where the gap between the rich and poor widens."
Increased Poverty: "For those who are already struggling, inflation can push them further into poverty. When prices go up but incomes don’t, basic necessities like food and housing become harder to afford, leading to increased poverty in our community."
Social Unrest: "When people struggle to make ends meet and see their quality of life declining, it can lead to frustration and anger. In extreme cases, this can lead to social unrest, with protests and conflicts arising as people demand change."
Political Impacts
Finally, Professor Penny addressed the political effects of inflation.
"Inflation can also have a big impact on our government and politics," she explained.
Loss of Government Credibility: "If inflation gets out of control, people may lose trust in the government’s ability to manage the economy. This loss of credibility can make it harder for the government to lead and implement policies."
Pressure for Policy Changes: "High inflation often leads to pressure on the government to take action, whether it’s changing interest rates, cutting spending, or introducing new policies to stabilize prices. This pressure can lead to significant policy shifts."
Potential for Regime Change in Extreme Cases: "In the most extreme cases, if inflation causes enough hardship and unrest, it can even lead to a change in leadership or regime. People might demand new leaders who they believe can better manage the economy."
As Professor Penny finished her explanation, the townsfolk of Econoville realized that inflation was not just an abstract concept but something that could deeply affect every aspect of their lives. They understood that managing inflation was crucial not only for their own financial well-being but also for the stability of their society and government.
With this newfound understanding, the people of Econoville vowed to stay informed and engaged, knowing that by working together, they could help keep their town prosperous and peaceful, no matter what economic challenges came their way.
The town of Econoville had grown wiser with each lesson from Professor Penny. They now understood what inflation was, what caused it, and the various impacts it could have on their lives. But Professor Penny knew there was one more important lesson to share: how to control inflation.
One crisp morning, she gathered the townsfolk in the square once again. "My dear friends," she began, "now that you know how inflation can affect our economy, society, and politics, it’s time to talk about what we can do to keep it in check. There are several ways we can control inflation, and they fall into three main categories: monetary policy, fiscal policy, and supply-side policies."
The townsfolk, eager to learn, listened attentively as Professor Penny explained.
Monetary Policy
"First," she said, "let’s talk about monetary policy. This is how the town’s bank—the Bank of Econoville—can manage the amount of money circulating in our economy to control inflation."
Interest Rate Adjustments: "One of the most powerful tools the bank has is the ability to adjust interest rates. If inflation is rising too quickly, the bank might raise interest rates to make borrowing more expensive. This encourages people to save more and spend less, which can help slow down inflation."
Open Market Operations: "Another tool is open market operations, where the bank buys or sells government bonds. If they sell bonds, it pulls money out of circulation because people are paying for these bonds, reducing the amount of money available for spending. This can help lower inflation."
Reserve Requirements for Banks: "The bank can also change the reserve requirements for other banks—this is the amount of money banks must keep in reserve and not lend out. If the reserve requirement is increased, banks have less money to lend, which can reduce spending and help control inflation."
Fiscal Policy
"Next," Professor Penny continued, "there’s fiscal policy. This is about how the town’s government manages its spending and taxation to influence the economy."
Government Spending Cuts: "If inflation is getting too high, the government might decide to cut back on its spending. By reducing the amount of money flowing into the economy, they can help reduce overall demand and bring prices down."
Tax Increases: "Another way to control inflation is by increasing taxes. Higher taxes mean people have less money to spend, which can reduce demand for goods and services, helping to lower inflation."
Debt Management: "The government can also manage its debt more carefully. If they borrow less, there’s less money being pumped into the economy, which can help keep inflation in check."
Supply-Side Policies
"Finally," said Professor Penny, "there are supply-side policies. These are strategies designed to increase the supply of goods and services in the economy, which can help reduce inflationary pressure."
Deregulation: "Deregulation involves removing unnecessary rules and restrictions on businesses. If businesses can operate more freely, they might be able to produce goods and services more efficiently and at a lower cost, helping to keep prices stable."
Privatization: "Privatization means transferring ownership of certain services or industries from the government to private companies. The idea is that private companies might be more efficient and competitive, which could lead to lower prices and less inflation."
Improving Labor Market Flexibility: "Lastly, improving labor market flexibility means making it easier for businesses to hire and manage workers. If businesses can adjust more quickly to changes in demand, they’re better equipped to keep costs down, which can help prevent prices from rising too quickly."
As Professor Penny finished her lesson, the townsfolk of Econoville felt empowered. They now knew that inflation wasn’t just something that happened to them—it was something they could influence through careful and thoughtful actions. They understood that controlling inflation required cooperation between the Bank of Econoville, the government, and businesses, each playing their part to keep the economy stable.
With this comprehensive knowledge, the people of Econoville were ready to face the future with confidence, knowing that they had the tools and understanding to manage inflation and keep their beloved town prosperous and thriving for generations to come.
The people of Econoville had come a long way in their understanding of inflation. They had learned what inflation was, what caused it, how it affected their lives, and the various ways to control it. But Professor Penny had one final lesson for them—a lesson drawn from history.
On a cool autumn day, she gathered the townsfolk in the square once more. "Today," she began, "we’ll look at some real-life examples from history that show us just how powerful and sometimes dangerous inflation can be, as well as how it has been successfully managed in the past."
The townsfolk, curious to hear stories from other times and places, listened closely as Professor Penny began her tale.
Hyperinflation Cases
"Let’s start with some of the most extreme cases of inflation—what we call hyperinflation. These are times when prices spiral out of control so fast that money loses its value almost overnight."
Weimar Republic (Germany, 1923): "In the early 1920s, after World War I, Germany faced a terrible period of hyperinflation. The government printed massive amounts of money to pay off war debts, leading to prices doubling every few days. People needed wheelbarrows full of cash just to buy a loaf of bread. This economic chaos contributed to social unrest and paved the way for significant political changes in Germany."
Zimbabwe (2008-2009): "In Zimbabwe, hyperinflation reached unimaginable levels. At its peak in 2008, prices were doubling every 24 hours. The government printed more and more money, but it only made things worse. People were using trillion-dollar bills that couldn’t even buy a cup of coffee. Eventually, Zimbabwe had to abandon its own currency and use foreign currencies instead."
Venezuela (2016-present): "Venezuela has been experiencing hyperinflation since 2016, driven by a mix of economic mismanagement, political instability, and a collapse in oil prices. Prices have risen so fast that the Venezuelan bolívar has become nearly worthless, leading to widespread poverty and a humanitarian crisis. Many people have fled the country in search of better opportunities elsewhere."
Periods of High Inflation
"Now," Professor Penny continued, "not all inflation is as extreme as hyperinflation. Sometimes, countries experience periods of high inflation that, while not as devastating, still cause significant economic challenges."
United States (1970s): "In the 1970s, the United States went through a period of high inflation, partly due to rising oil prices and economic policies that increased demand. Prices for everyday goods soared, and people’s savings lost value. This period, known as ‘The Great Inflation,’ led to a lot of uncertainty and hardship for many Americans."
United Kingdom (1970s): "The UK also faced high inflation in the 1970s, driven by similar factors, including rising oil prices and wage demands. Inflation reached double digits, causing economic instability and leading to difficult decisions by the government, including wage controls and spending cuts."
Latin America (1980s-1990s): "Many countries in Latin America, including Argentina, Brazil, and Mexico, experienced high inflation during the 1980s and 1990s. Economic mismanagement, debt crises, and political instability contributed to rising prices, which eroded people’s savings and made it hard for businesses to plan for the future. These periods were marked by economic hardship and social unrest."
Successful Inflation Management
"But," Professor Penny said with a smile, "history also shows us that inflation can be managed successfully with the right policies and leadership. Let’s look at a few examples of how countries have tamed inflation."
Paul Volcker’s Fed Policies (USA, early 1980s): "In the early 1980s, the United States was still struggling with high inflation. Paul Volcker, the head of the Federal Reserve, decided to take drastic action. He raised interest rates to very high levels, which slowed down the economy but also brought inflation under control. While it caused a short-term recession, Volcker’s tough policies eventually led to a period of economic stability."
New Zealand’s Inflation Targeting (1990s): "New Zealand was one of the first countries to adopt inflation targeting as a central policy in the 1990s. The idea was to set a clear target for inflation and use monetary policy to keep inflation within that range. This approach helped stabilize prices and set a precedent that many other countries have followed."
Brazil’s Real Plan (1994): "In the early 1990s, Brazil was suffering from high inflation. In 1994, the government introduced the Real Plan, which involved creating a new currency, the real, and implementing strict monetary and fiscal policies to stabilize the economy. The plan was a success, bringing inflation down from triple digits to single digits within a year and setting Brazil on a path to greater economic stability."
As Professor Penny finished her stories, the people of Econoville were amazed by the lessons of history. They realized that while inflation could be a powerful and sometimes destructive force, it was not invincible. With the right knowledge, policies, and leadership, even the most challenging inflationary periods could be overcome.
The people of Econoville felt a deep sense of gratitude for Professor Penny’s teachings. They knew that by learning from the past, they were better equipped to protect their town’s future. And so, with a newfound appreciation for the importance of sound economic management, they went back to their lives, ready to face whatever challenges lay ahead with wisdom and confidence.
The people of Econoville had learned so much about inflation, its causes, its effects, and how to manage it. But Professor Penny wasn’t quite finished. She knew that to truly understand inflation, the townsfolk needed to be aware of some related economic concepts that were equally important.
On a bright morning, she gathered the townsfolk one last time. "Today," she began, "we’re going to explore a few more economic concepts that are closely related to inflation. Understanding these will give you a more complete picture of how our economy works."
Deflation
"First," Professor Penny said, "let’s talk about deflation. While inflation is all about rising prices, deflation is the opposite—it’s when prices actually fall over time."
Definition and Causes: "Deflation happens when there’s a decrease in the general price level of goods and services. This can be caused by a drop in demand, an increase in supply, or improvements in technology that make production cheaper. Sometimes, deflation can occur after a period of inflation, as the economy tries to correct itself."
Effects on Economy: "At first, falling prices might sound like a good thing, but deflation can be dangerous. When prices drop, people might delay their purchases, expecting prices to fall even further. This can lead to less spending, lower production, and higher unemployment, creating a vicious cycle of economic decline."
Historical Examples (e.g., Great Depression): "One of the most famous examples of deflation occurred during the Great Depression in the 1930s. Prices fell sharply, and the economy collapsed as businesses failed and unemployment soared. It took years of effort and significant government intervention to pull the economy out of this deflationary spiral."
Stagflation
"Next," Professor Penny continued, "there’s a concept called stagflation, which combines the worst of both worlds—high inflation and economic stagnation at the same time."
Combination of High Inflation and Economic Stagnation: "Stagflation is a situation where inflation is high, but economic growth is slow, and unemployment is rising. Normally, you’d expect inflation to go up when the economy is doing well, but stagflation is a scenario where the economy is struggling even as prices keep rising."
Causes and Effects: "Stagflation can be caused by a variety of factors, such as a sudden increase in the cost of essential goods, like oil, or poor economic policies that restrict growth while still allowing prices to rise. The effects of stagflation are particularly challenging because traditional economic tools often make one problem worse while trying to fix the other."
Historical Examples (e.g., 1970s Oil Crisis): "A well-known example of stagflation occurred in the 1970s when oil prices shot up due to an oil embargo. The cost of energy skyrocketed, leading to high inflation, while economic growth slowed down, causing unemployment to rise. This period was a difficult time for many countries, as they struggled to deal with these conflicting economic challenges."
Phillips Curve
"Lastly," Professor Penny said, "let’s explore the Phillips Curve, a concept that tries to explain the relationship between inflation and unemployment."
Inverse Relationship Between Unemployment and Inflation: "The Phillips Curve suggests that there’s an inverse relationship between unemployment and inflation—when one goes up, the other tends to go down. In the short run, this means that if a government tries to reduce unemployment by stimulating the economy, it might lead to higher inflation, and vice versa."
Short-Run vs. Long-Run Phillips Curve: "However, economists have found that this relationship doesn’t always hold in the long run. In the short run, the trade-off might exist, but over time, factors like expectations of future inflation can change the dynamics. The long-run Phillips Curve is often depicted as vertical, suggesting that there’s no long-term trade-off between inflation and unemployment."
Critiques and Modern Interpretations: "The Phillips Curve has been debated and critiqued over the years. Some economists argue that it oversimplifies the relationship between inflation and unemployment, especially in the long run. Modern interpretations often incorporate expectations and other factors that influence both inflation and employment, leading to more complex models of how these variables interact."
Conclusion
As Professor Penny wrapped up her final lesson, the townsfolk of Econoville felt a deep sense of satisfaction. They had journeyed through the complexities of inflation, learned about its causes and effects, explored how to control it, and even delved into related economic concepts like deflation, stagflation, and the Phillips Curve.
"With this knowledge," Professor Penny said with a smile, "you are now well-equipped to understand the forces that shape our economy. You’ve seen how inflation can be both a challenge and a manageable part of economic life, depending on how we respond to it. And you’ve learned from history that even in the face of tough economic situations, there are always tools and strategies we can use to improve our situation."
The people of Econoville thanked Professor Penny for her wisdom and guidance. They knew that, armed with this knowledge, they could face the future with confidence, ready to navigate the ups and downs of the economy. And so, with a deeper understanding of the world around them, they returned to their lives, prepared to make informed decisions that would keep their town prosperous and thriving for generations to come.
_____
I hope you liked the story. I am experimenting with the story format with money series. Let me know if you have any feedback. See you next time.
SOMEONE CAN BENEFIT FROM IT
If you find this post helpful, we would be grateful if you could take a moment to share it with others who might benefit from it. Your kindness and support mean a lot to us.
DYNAMIC CONTENT
No one knows how deep a rabbit hole can go.
All our posts are regularly updated as soon as new information becomes available. We also keep note of the questions asked by our readers and add their answers to the article. So, stay curious and ask questions in the comments.
ABOUT THE AUTHOR
Hey everyone, I'm Garvit Sahdev 😎. I'm on a mission to gain a deeper understanding of the world, and to develop solutions that can trigger significant global change.
My curiosities span various domains including food, business theories, material science, market size calculations, economics, politics, and sports, etc. 🧐
Professionally, I have a diverse background spanning startups, consulting, policy development, market research, system building, ISO, colour physics, nanomaterial synthesis, textile chemistry, etc. 🐘
Note: Generative AI has been used for writing this piece under the supervision of the author.
Thanks for reading The Thoughtful Tangle! Subscribe to continue reading deeply researched stories about the interesting concepts that shape our world. ❤️