We constantly hear about the issue of inflation. Especially in 2022, inflation has become a problem that is grabbing the headlines of all newspapers.
But this is not a problem only of the year 2022. In many countries, inflation has been a recurring problem in the economy. Others have had episodes of significant inflation in periods of their history due to the economic policies adopted.
Knowing how complex inflation is and the interest it arouses in many today we will tell you what the dreaded inflation is about and what produces it.
Without more to add let’s start.
What is inflation and elements that produce it?
In simple terms, inflation is the generalized price increase.
To be a little more precise, inflation is an economic phenomenon that describes the sustained and general increase in prices in a particular market.
This means that, limiting it to a particular market, inflation can be local, regional, or global. Price increases are measured in a specific geographical and political area and depend on the economic policies that are developed in this area.
That is why it is so important that the rulers understand inflation to control it. However, we often find ourselves with rulers who apply economic policies that demonstrate the absolute ignorance of this situation.
That is why today we will talk about the fearsome inflation and the elements that can condition its behavior.
Is inflation good or bad?
Inflation is a phenomenon that in small quantities can be beneficial to the economy and competitiveness, but in large quantities creates instability in the economy.
Small doses of inflation promote that money remains invested to compensate for the loss of value. This promotes investment, business, and productivity.
However, high inflation devalues the money people earn, keeps moving and discourages saving. It can begin to promote capital flight to other currencies that do not lose value.
So, a little inflation is healthy (from 0 to 2%), a lot is a scourge for the economy. High inflation can end up in an inflationary spiral, which we will see below.
What is an inflationary spiral?
The expectation of rising prices can cause a phenomenon known as an “inflationary spiral.” An inflationary spiral is a situation in which all market players increase prices in anticipation of future price increases. This in turn causes further price increases.
It is a factor that has a component in the forecasts, budgets and expectations of businesses and people.
That is, inflation can cause more inflation. How we view inflation is a complex phenomenon that feeds itself.
Example of elements that produce inflation: Oil and Russia’s invasion of Ukraine.
Not all price increases are the product of inflation. But there are price increases that are inflationary, because they affect all products, or a wide range of them.
This is the case with the price of oil that when it rises, usually causes an increase in inflation. This is because oil is a raw material that is used in the production of fuels, lubricants, fertilizers, and plastics. Fuel is necessary for the transport of goods and in electricity generation, affecting almost all products and household expenses.
On the other hand, plastic, a derivative of petroleum, is a widespread raw material, affecting the costs of many products. Finally, fertilizers are used in the agri-food industry, and are fundamental to the price of food.
Therefore, any factor that causes the increase in oil prices produces inflation, and this is where the Russian invasion of Ukraine comes in, as we will see below.
The Russian invasion of Ukraine and inflation.
Russia is one of the largest oil exporters. Sanctions that seek to curb the war are affecting the availability of agricultural products, fertilizers, and oil worldwide.
Ukraine is also a large supplier of fertilizers and cereals worldwide. The war also restricts the production and movement of goods, from countries that are large producers.
Restrictions on the supply of oil, cereals and fertilizers drive the prices of raw materials needed for various key sectors of the economy. This is dangerously boosting inflation, jeopardizing the stability of the world economy.
Inflation, basic elements that produce it.
Knowing this, we will proceed to analyze in detail what are the main elements that produce inflation.
As we discussed, inflation is a complex phenomenon. The elements that can drive inflation are varied, and these elements are interconnected. Below, we’ll point out the basic elements that drive inflation and its relationships:
1. Increase in prices of basic inputs.
There are inputs that are basic for the industry because of their broad impact. In the previous video we mentioned oil, necessary to produce fuel, plastics, lubricants, and fertilizers.
There are also other inputs that can greatly impact prices. One of them is the fertilizers or components that are used for its manufacture. This component affects food production and food prices.
Energy and water are usually other inputs that if their price is affected affect prices throughout the supply chain.
If we consider that labor is an input of the productive chain, raising wages without considering productivity can induce inflation.
2.- Excessive increase in liquidity due to the issuance of money.
Let’s see why “unbacked” monetary issuance causes inflation:
- The issuance of money generates an increase in the demand for goods and services. People who have more money consume more.
- Part of these inputs for production can be obtained in the local market, but others will have to be imported.
- Additionally there are finished products that are not produced in the country and will have to be imported.
- The government should have international reserves to meet the increased demand for raw materials and imported products.
- This money can go to acquire finished products, semi-finished or raw materials that will meet the growth of demand due to money issued.
- There must be a ratio between the growth of liquidity and that of international reserves.
Depending on the type of economy of a country, the ratio of reserves or liquidity will be higher or lower. The more outputs and inputs produced domestically, the fewer international reserves will be needed. However, there are no self-sufficient countries.
If there are not enough reserves to import or production is not able to respond to demand, an “auction” situation is generated between available goods and services and consumers. This auction effect is the cause of inflation, which always appears when supply is insufficient to meet demand. That is why stimulating demand can be inflationary if there is no response capacity of the country’s productive, importing and financial apparatus.
The complexity of inflation. One more inflationary element.
As we see the issue of inflation is complex. We have addressed 2 of the elements that produce inflation, but they are not the only ones.
In the next section we will discuss how taxes and government spending can severely affect inflation.
Additionally, this is the opening to give an important debate that has been given in different instances. The key question is do corruption and inflation have any connection?
We anticipate that the answer is yes, because corruption is nothing more than misused public spending. However, let’s see how public spending can become an inflationary element.
3. – Taxes and public spending.
Taxes turn out to be a basic input, the product of living in society. Paying taxes guarantees administrative procedures, control, security and some services considered essential such as identity, nationality, among others.
Unlike other inputs, taxes are not optional. Everyone pays taxes to a greater or lesser extent. This is why taxes can become one of the main reasons for inflation.
As with any input, its efficient use can mitigate its inflationary effects. But high taxes used inefficiently are a guarantee of high inflation. To ensure the efficient use of public resources, two conditions are required, transparency and social control.
The absence of transparency makes it impossible to assess whether public spending is being carried out in the areas that the population needs. On the other hand, if there is no social control, unnecessary or “diverted” public spending cannot be stopped.
This explains why corruption is one of the main drivers of inflation, as we will see below.
Public spending and corruption
Excessive public spending in unnecessary and/or overpriced areas may be the key to inflation in countries with higher corruption rates. Perhaps inflation may even become a measure of corruption in these countries.
Public spending is necessary to guarantee essential social goods such as health, education, security, justice, among others. But the way this spending is executed should be open to citizen scrutiny.
For this reason, some countries opt for decentralization so that power and public spending are distributed. In addition, in this way the executors of the expenditure are closer to those who are their beneficiaries and comptrollers. This leads to better control and accountability.
The way to reduce the inflationary incidence of public spending and taxes is to control public spending and direct it to needs that have the potential to increase productivity and well-being.
4.- People’s expectations.
If people expect inflation, they will ask for wage increases and increase the products they sell. This is why the expectation of inflation generates inflation.
If there is permanent inflation, producers, salespeople and wage earners will be in a race to maintain their income. Based on that they will be looking to increase their profit or their salary, which in turn will maintain inflation.
To reduce inflation, alternatives should be sought to increase income while maintaining fixed expenses. Basically, productivity and efficiency must be sought. This can be done by improving production processes, shortening marketing chains or removing bureaucratic steps that do not add value to the product.
Companies, merchants and employees will seek to cut expenses.
Many times the solution of companies and merchants is first of all to reduce staff. However, if there is an increase in unemployment this can also be harmful.
If the staff that is cut ends up working in another sector where these personnel are needed, the objective is achieved. However, if these cuts imply unemployment and, therefore, less flow in the economy, a recession can also be generated.
Recession can generate inflation as we will see below.
5.- Decrease in productivity and/or sales.
The cost of a product is made up of variable costs and fixed costs. Variable costs are directly associated with the units produced. This means that if my production increases or decreases, these costs will increase or decrease proportionately.
However, fixed costs remain despite the increase or decrease in production. These costs can be rent of the premises, salary of the accountant and salaries that do not vary according to productivity.
The sharp decline in demand can decrease demand and with it sales.
If there are fewer sales, the variable costs will be maintained per unit produced. But the fixed costs will be distributed among fewer units and therefore will end up increasing per unit sold.
Productivity is a measure of this and although sales are maintained if fixed costs grow and variables are maintained we will also see a similar effect.
That is why one of the most difficult elements of inflation to manage is economic flow and productivity.
Inflation, an ally of care that we must control
As we mentioned, keeping inflation low is healthy for productivity. On the other hand, excessive inflation causes the economy to become unbalanced and scares away savings and investment.
We must aim to improve the ways of controlling inflation and for this we need knowledge.
For this reason, Gustavo Mirabal Castro promotes financial education so that we can take charge of our personal finances. To grow in the good times and cope well with the difficult times. Financial knowledge can also help us anticipate situations of risk for our assets and anticipate.
We can follow Gustavo Mirabal to prepare for a better future with financial knowledge that will help us achieve financial freedom.