## How to Understand the Fall of Purchasing Power: A Guide to the Definition of Inflation

**Why is your money worth less every year?**

You have probably wondered why a coffee that cost 2 euros ten years ago now costs 4? This economic phenomenon has a name: inflation. It represents the gradual reduction of the purchasing power of a given currency, leading to a sustained increase in the prices of goods and services in an economy. Unlike simple isolated price changes, the definition of inflation encompasses a widespread rise in costs affecting almost all sectors, and this in a sustained and not temporary manner.

**The three inflation-generating mechanisms**

Initially, we can distinguish two simple factors: the rapid increase in the amount of money in circulation, or a supply shortage in the face of strong demand. Historically, when the conquistadors brought massive amounts of gold and silver from America in the 15th century, these precious metals flooded European markets, causing uncontrollable inflation.

But there are three main forms of inflation, according to the triangular model of economist Robert J. Gordon:

**Demand-pull inflation** occurs when spending surges. Imagine a bakery producing 1,000 loaves of bread weekly. Everything runs smoothly until the day the economy improves and consumers can spend more. The demand for bread triples, but the bakery cannot immediately increase its production – its ovens and staff have reached their limits. Faced with this relative scarcity, the baker raises his prices. If this increase in demand spreads to all products (milk, oil, etc.), it is generalized demand-pull inflation.

**Cost-push inflation** works differently. Suppose our baker has invested in new equipment and hired staff to produce 4,000 loaves of bread per week. But suddenly, the wheat harvest collapses regionally. To obtain his raw material, he has to pay more. He has no choice but to raise the price of his bread, even if customer demand has not changed. Increases in the minimum wage or government tax levies can also create this form of inflation. On a large scale, resource shortages, tax increases, or declining exchange rates are the main causes.

**Built-in inflation** ( or trailing effect ) comes from the economic past. It kicks in when the two previous persistent forms create inflationary expectations. Employees, having experienced years of inflation, demand higher wage increases. Companies, seeing their costs rise, raise their prices. Workers then demand even higher wages in the face of the high cost of goods. This price-wage spiral can perpetuate itself, creating self-sustaining inflation.

**How to measure inflation?**

To combat inflation, it must first be quantified. This is the role of the Consumer Price Index (CPI), used in many countries. This index tracks the price changes of a wide range of goods and services purchased by households by calculating a weighted average. If your reference year shows a CPI of 100 and two years later the score is 110, it means that prices have risen by 10%.

**Government Responses**

When inflation becomes too high, governments deploy two main arsenals:

Monetary policy first. Central banks raise interest rates, making borrowing more expensive. Consumers and businesses spend less, demand falls, and inflation slows down. It is also an incentive to save. The downside: economic growth can also slow.

The budget policy then. By increasing income taxes, governments reduce the available purchasing power, decreasing demand and theoretically inflation. But this approach proves politically delicate, as the public is reluctant to tax increases.

**The benefits and pitfalls of inflation**

Moderate inflation stimulates the economy. It encourages consumers and businesses to spend and invest now rather than wait until tomorrow, when their money will be worth less. Businesses sell at higher prices and improve their margins. It is also preferable to its opposite, deflation, where prices fall. In a deflationary environment, buyers postpone their purchases in hopes of future discounts, stifling demand and increasing unemployment.

However, uncontrolled inflation becomes catastrophic. It erodes the wealth of savers: 100,000 euros under the mattress today will not be worth 100,000 euros in ten years. Worse, hyperinflation (increase above 50% monthly) devastates economies. When the prices of basic items triple in a matter of weeks, money becomes almost useless.

High inflation also creates uncertainty. Individuals and businesses become cautious, reduce investments, and growth stagnates.

**Conclusion: balance remains key**

The definition of inflation is accepting that our purchasing power decreases over time. This is inherent in modern economies using fiat currency. When well managed, inflation stimulates spending and investment. When poorly controlled, it ruins lives and economies. The challenge for governments is to wisely implement flexible monetary and fiscal policies that can adapt without causing collateral damage. It is a fragile balance that all nations seek to maintain.