Why are your purchases getting more and more expensive? Understanding the definition of inflation

Introduction: The phenomenon that empties your pockets

You have surely noticed that your money doesn't go as far as it used to. That coffee that cost 2 euros a few years ago now costs 3 or 4. Your grocery basket is exploding every month. This economic reality has a name: inflation. But beyond this simple observation, what is the real definition of inflation?

Inflation is not just a price increase here or there. It is a widespread and lasting increase in the cost of almost all goods and services in an economy. Unlike a simple relative price variation ( where only one item becomes more expensive ), inflation affects the entire economic system over an extended period.

The definition of inflation: Beyond the numbers

To fully understand this phenomenon, one must grasp that inflation essentially represents the loss of value of your currency. If you have 1,000 euros in your wallet today, that 1,000 euros will only allow you to buy 900 euros worth of goods next year during a period of inflation. Your purchasing power is gradually eroding.

Governments measure this erosion in annual percentages. An inflation rate of 3% means that prices have increased on average by 3% compared to the previous year. This is a natural phenomenon in modern monetary systems, but when it becomes uncontrollable, it can transform an entire economy.

Where does this inflation come from? The three main mechanisms

When demand exceeds supply

Imagine a popular bakery that sells 1,000 loaves of bread per week. It operates at full capacity. Suddenly, economic conditions improve: consumers have more money to spend. Demand rises to 1,500 loaves, but the ovens cannot produce more. What does the baker do? He raises prices. Some customers will pay more to get their bread. This is demand inflation: too much money chasing too few goods.

This phenomenon amplifies when it affects several sectors at once. If the demand for milk, oil, meat, and vegetables increases simultaneously, prices rise everywhere. Consumers spend more, producers cannot keep up, prices explode.

When production costs increase

Here is a different scenario: our baker has finally built new ovens and hired staff to produce 4,000 loaves of bread per week. Supply meets demand, everyone is happy. But one morning, disaster strikes: the wheat harvest has failed. There isn't enough grain for all the bakers in the region. The price of wheat skyrockets on the market.

Our baker has to spend a lot more to obtain his raw materials. Therefore, he must raise the price of bread, even though no one has asked for more bread. This is cost-push inflation: production costs rise, and prices rise accordingly.

This inflation can also be triggered by an increase in government taxes, a rise in minimum wages, or foreign currencies that appreciate ( making imports more expensive). It is a problem of insufficient resources facing constant needs.

When inflation feeds on itself

The third form may be the most insidious: embedded inflation. Imagine that for several years in a row, inflation has been present. Workers now expect it to continue. They therefore demand higher wages to protect their purchasing power. Employers, seeing their costs rise, increase the prices of their products. Prices rise, workers again demand higher wages. A cycle sets in.

It is the price-wage spiral: each price increase leads to a demand for wage increases, which leads to new higher prices, which leads to new wage demands. A machine that accelerates on its own, fueled by the expectations that inflation will continue.

How Governments Combat Inflation

Letting inflation progress without limits is catastrophic for the economy. Therefore, governments and central banks are deploying several strategies.

Increase interest rates

It is the most classic tool. When interest rates rise, borrowing becomes expensive. An auto loan, a mortgage, a credit card: everything becomes less attractive. Consumers spend less, businesses invest less. Demand decreases, which slows down prices.

The advantage: it is effective. The disadvantage: it can slow down economic growth. People and businesses, hesitant to borrow, spend less, which can create unemployment.

Modify the budget policy

The government can also increase income taxes. If your disposable income decreases, you spend less. Demand decreases, inflation slows down. But beware: increasing taxes is unpopular, and it can also slow down the economy.

Reduce the money supply

Central banks can also reduce the amount of money in circulation, a technique called quantitative tightening (QT). If less money circulates in the economy, fewer people can spend, so prices rise less. However, evidence of the effectiveness of this method is limited in practice.

How to Measure Inflation: The Price Index

To know if inflation is a problem, it must first be measured. This is the role of the consumer price index (CPI) in most developed countries.

The CPI works like this: a representative basket of goods and services that households regularly purchase is selected (food, electricity, transportation, clothing, etc.). The total price of this basket is evaluated at different periods. The figures are then compared.

For example, if the basket was worth 100 euros in 2020 (base year) and is worth 110 euros in 2024, we can say that inflation has been 10% over these four years, or an average of 2.5% per year. Statistical organizations like INSEE in France regularly collect this data to ensure accuracy.

The good sides of inflation (yes, there are)

Although inflation is often viewed negatively, moderate inflation is actually beneficial for the economy.

First, it encourages spending and investment. If you know that your money will be worth less tomorrow, you are incentivized to use it today. You buy that house, you launch that project, you borrow to invest. It's good for economic growth.

Secondly, it allows companies to increase their profits. During periods of inflation, companies can raise their prices, which increases their margins. If they justify the increase well, they can even sell more by finding customers willing to pay. This is good for employment and innovation.

Thirdly, moderate inflation is preferable to deflation. Deflation is the opposite: prices fall. This seems good for the consumer, but it's a trap. If prices are falling, why buy today when it will be cheaper tomorrow? People postpone their purchases, demand collapses, companies lay off workers, unemployment rises. Historically, periods of deflation have always been accompanied by severe economic crises.

The downsides: When inflation spirals out of control

But too much inflation is an economic disaster.

Hyperinflation is the worst-case scenario. It's when prices rise by more than 50% in a month. A product that costs 10 euros becomes 15 euros a few weeks later. People rush to stores to spend their money before it becomes completely worthless. The currency collapses, wages do not keep up, and the money becomes practically worthless. The economy paralyzes.

Economic uncertainty also paralyzes investments. If no one knows where the economy is headed, companies freeze their projects, people save rather than spend, and growth comes to a halt.

Wealth erosion particularly affects savers. If you have 100,000 euros hidden under your mattress and inflation reaches 10% per year, you lose 10,000 euros in purchasing power each year without doing anything. It's a silent but real loss of wealth.

Conclusion: Finding the right balance

The definition of inflation is therefore this slow erosion of the purchasing power of your currency. It is an inevitable phenomenon in modern economies, but one that can be controlled.

An inflation rate of 2-3% per year is generally considered healthy: enough to encourage spending and investment, but not so much as to cause damage. Beyond that, it becomes dangerous. Governments must constantly adjust their monetary and fiscal policies to maintain this precarious balance.

Economic history shows that governments that manage inflation well thrive, while those that let it run rampant see their economies collapse. True economic wisdom lies in moderation: not too much inflation, not too little, but just enough for the economy to remain dynamic and stable.