Investopedia defines inflation as ‘the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buy less than it did in prior periods.’
That answer will earn you an A in economics class – not an A-plus because we can add to the complexity of the definition given and use even bigger words – but luckily, we are not in an economics class. Last year you bought a loaf of bread for R10. This year you bought a loaf of bread for R15. See, you understand inflation.
Inflation (increasing prices) is what we expect to happen, so in itself, it is not a bad thing, but like everything else, anything extreme is going to give you problems. Last year you bought a loaf of bread for R10. This year you bought a loaf of bread for R7. This is called deflation. You also get something called hyperinflation where, yep, you guessed it, you paid R10 last year but this year you are paying R30 for the loaf of bread. When economists talked about the currency has lost value, this is what they are referring to: last year you got an entire loaf of bread for your R10, this year you are only getting two-thirds of the loaf for R10.
When I was a kid I couldn’t understand why the government doesn’t just print more money and give it to the poor people so that they could buy food and clothes. Money is like any other goods where the value of money is wrapped up in the demand for it. I love strawberries. Strawberries this time of the year is very, very expensive because they are imported from – when looking at the price – the furthest corner of the earth. In three months, I would be able to buy strawberries by the bucket from the roadside for next to nothing, because they will be in season. When there are a lot of strawberries, they are worthless. When there is a lot of money, it is worthless. If governments just willy nilly start printing money, the prices of everything will rise because the money – like the strawberries – will be worthless.
In the previous blog post I wrote about government spending and although we want governments to spend to create a better place to live for all the people in the country if the government spends too much – or on the wrong thing, e.g. not enough to help grow the economy – then you will also see a rise of inflation. If the government spends all their money on e.g. social grants, but they do not spend any money on infrastructure, communications and other things that make it profitable to run a business, the private businesses will have to make those investments and developments. The more money they are spending on that, the less profit they make, the less taxes they pay, the less money governments have to do the things that they need to do. Government spending stimulates the economy, but you also need government investment to ensure that the economy grows in the future.
What happens if the government spends more money than what they get in taxes? The government then resorts to what is called deficit financing – and often that means that they print more money…
Don’t forget the general economic principles of supply and demand – the pricing of the strawberries is directly related to supply and demand. What happens if you have population growth? You create more demand in the market and prices will rise until the supply side can catch up with the demand. We read recently about the fires in Australia and the floods in Texas – in both cases, agricultural produce and land were destroyed, which will lead to scarcity – i.e. the demand has stayed the same, but the supply side cannot deliver as per normal – the net result here would also be an unnatural rise in prices (i.e. inflation will go up).
When we look at the elements that make up pricing, it also includes labour, taxes, etc. If the minimum wage increases, the output costs will increase. Maybe. This has been in the news so often and it is not a linear argument, because you have to bring in productivity. When people are paid fair wages, they tend to stay in the jobs for a longer time. This will result in a saving for the company on training, uniforms and a range of other expenses. Remember that your local burger joint does not decide on inflation in isolation. If the unions e.g. negotiate healthcare for all workers, it will come at a higher price to the company (again, not linear), but it is also an expense that is taken away from the government. Although this is not a rand for rand exchange, it is substantial enough to be considered – and perhaps we’ll do a specific write-up on this one!
Inflation goes hand in hand with the Consumer Price Index. The Consumer Price Index takes a basket of goods and compares the price to the previous year.
$$ CPI_t = \begin{pmatrix}{ C_t \over C_o } \end{pmatrix} 100 $$ where
- CPIt = consumer price index in the current period
- Ct = cost of the market basket in the current period
- Co =. Cost of the market basket in the base period
The basket of goods is supposed to be representative of what the average household in the population will need and purchase – so it includes both goods and services. The basket gets divided into categories, e.g. food, transport, healthcare, clothing, etc. Every category is then weighted to show how much an average household would spend on this category – so if in your country housing is expensive but the food is cheap, the basket will give more ‘basket space’ to housing than to food because you are spending a bigger part of your salary on housing than on food. Economists will use this basket to calculate the cost of living. It is important that this basket gets updated over time – e.g. this year we see a lot of countries including hand sanitiser into their basket of goods. It is fun to look at the basket over time – we have moved away from gold chains towards smartwatches, from canteen sandwiches to fitness equipment – because it is like a time capsule on where we are on technological development and fashion!
Every country can decide which and how many items they want in their basket. The Guardian reported that the UK added 17 items, removed 10 and left 729 items unchanged. The pandemic led to changing lifestyles, so in came home improvement, smart/WIFI lightbulbs and electric cars and out went white chocolate bars (replaced by malted chocolate sweets such as Maltesers), fruit smoothies and ground coffee (replaced by coffee sachets)*.
Ceyda Oner from the IMF wrote an easy to understand article on inflation stating that ‘inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year’. Inflation is a result and to manage inflation, we have to manage the elements influencing inflation. Next time one politician blames another for high inflation, we need to ask the right questions: what caused the inflation? Was it something that better policy could have prevented or was it perhaps a natural disaster? Think of inflation as a test score. If your child is in danger of failed her grade, do you arrange for extra classes in the subjects that she battles with or do you change schools? You will only make the drastic decision to change schools if you have determined that the teacher is the cause of the bad grade result. It is the same with the economy. We need to ask the right questions and hold the right people accountable for the right actions. What we must not be is intimidated when our representatives and people in power throw around terms like they are objects with a life of their own that influence our worlds without us having any power or control.
*What does a country measure of inflation tell us about their culture? Canadians love their cars, Germans spend 32 % of total outlay on housing (vs 15 % in France), the high cost of owning a car in Japan has led to fewer people owning a private vehicle, Ethiopians spend most on food and beverage, Hong Kong unsurprisingly is spending on housing as well, Mexicans spend quite a bit on food – more than Americans, but less than Ethiopians, etc. Your inflation basket result can also tell you more about your own country, e.g. in South Africa we know that people in Limpopo (a province) spend a smaller fraction of their expenditure on housing and utilities than just about anybody else in SA, but they spend the greatest fraction on food.
Leave a Reply