Inflation Fundamentals

Inflation is the persistent and sustained rise in general price levels over a period of time. As this is one of the most generic definitions of inflation ever, let’s focus on the most important factor – Price. Price is said to be the monetary value of a product, so inflation occurs when there is a sustained increase in the monetary value of goods and services in an economy. That doesn’t sound like a bad thing, does it?

Well it depends on the side of the spectrum you are. When monetary value increases, it means that it takes more money to get a product. For instance, where there is a 10% inflation, it means that the monetary value of goods and services in a specified basket has increased in general by 10%. Let’s further assume that the economy is experiencing a growth and income levels rise by 10%. The 10% inflation is not much of an issue because the expenditure takes the same percent of income. Okoro, out of his N100 wage, buys corn for N50 but with the 10% inflation, corn now sells for N55. If Okoro’s income increases by 10% to N110, it wouldn’t make much of an effect because corn still takes the same percentage of his income – 50%. Inflation is not much of a bad thing in this case. As a matter of fact, it is expected – the economy is experiencing a growth after all. But when inflation rises and income doesn’t follow suit, we might begin to have a bit of a problem.

Demand-Pull Inflation

Theoretically there are two types of inflation. The first is demand-pull inflation, where there is more demand for a product than the supply of it. This is an inflation caused by too much money chasing few goods. The monetary value inadvertently increases because people have more money or are willing to pay more to own that product. In this situation, demand increases faster than supply, causing a scarcity which leads to an increase in prices like it happened in the US 1970s Gas Crisis. Another case is when there is a general rise in income levels and producers/sellers just increase their prices to get in on the action – think Udoji Awards. Income and by extension, demand, increases in period of growth (as in our first example above) and in periods of expansionary fiscal policy. Expansionary fiscal policy is when the government increases its spending and/or lowers taxes to release funds into the economy. However, there’s a kind that isn’t due to income – expectation of future inflation. In this case, people decide to stock up on products right now. In addition to rising growth and income levels, demand pull inflation also occurs because of expectation of higher prices. So this is a funny thing that happens when people decide to buy more of a product right now because they think the price will increase in future. The current demand drives prices up bringing what they fear upon them faster.

Cost-Push Inflation

On the other side of the inflation coin is Cost-push inflation. In this case, prices of goods and services rise because it costs more to produce those products (pun intended). This is quite logical, in the sense that, when cost of production increases, it is only normal to pass that on to the final consumers who then pay higher prices. A good example: Nigeria’s current inflation. Supply side inflation can be caused by factors ranging from exchange rate pressures to supply chain issues. For an economy that sources its inputs from abroad, devaluation and depreciation of its currency will definitely increase costs of production. Supply chain problems involve breakdown in distribution and sales channels, where producers have to pay more or encounter more risks in transporting and selling their produce.

How does Inflation Affect the Economy?

Inflation is one of the most dynamic issues in any economy. To understand this, we have to understand how the value of money works; having previously established that the value of money reduces with increase in inflation. Because prices of goods and services increase, the proportion of income that people spend may increase translating into lower savings and low standards of living because people will most likely be able to only afford the basic necessities. The hike in prices takes away any incentive to spend on luxuries, not necessarily because they don’t want to, but because they can’t afford to.

Above every other adverse effect, the worst impact is the loss of currency value and inevitable capital flight. The value of a unit of currency is the product that it can buy; its purchasing power. So in periods of inflation, the value of money drops because prices continue to rise requiring more currency for purchases. When the value of money drops, it loses its quality as a store of value and people would rather spend their disposable income than save or invest. People that really need to save would prefer to convert their monies to some other stable currency or commodity (Dollar or Gold) to hedge against the risk of their assets losing value.

Inflation is not always a bad thing. Matter of fact, economic authorities always seek to maintain a healthy level of inflation. What qualifies as healthy inflation? A slow and steady increase in prices that encourage expansion of productive capacities but also dissuade consumers from saving and investing excessively. Although 2% – 3% inflation is the acceptable threshold, a controllable single-digit inflation will do just fine. But you see those double digit disasters, they reduce trust in the currency and instead of spurring production and investment, they limit consumption.

Even worse than double digit inflation is hyperinflation. Hyperinflation is a rapid, excessive and uncontrollable inflation mostly depicted by at least 50% month on month inflation growth. According to history, it happens when the government of a country prints money indiscriminately to the extent that there is a glut in the market. This glut leads to an inability to control and maintain the value of the currency. With a lot of money in circulation and slowdown in production due to high costs, prices continue to rise and value of money inevitably drops like in Zimbabwe where there was a single Z$100 trillion note with about 231 million percent inflation in 2008.

How can Inflation Be Controlled?

Simple: Fight the cause. Because every economy is peculiar with its own drivers and dynamics, the situations driving inflation vary. For a demand pull inflation, the most efficient remedy is reducing money supply. When people have less money to throw around, this will slow down demand and inflation levels. Money supply can be controlled by increasing interest rates, restricting government spending and increasing taxes. The process is not as straightforward for a supply-side inflation. We are sure the CBN can relate.  Since there are a variety of costs involved in production, policy makers should be strategic towards these costs. Generally, the advisable solution includes reducing company taxes, ensuring a stable foreign exchange system for importation of raw materials, provision of infrastructures for production and distribution amongst others.