What is inflation, and why do economists keep an eye on it? Inflation is the rate at which the prices of goods and services increase. This can be dangerous, especially if inflation is compounded – when inflation is allowed to snowball over time. This can lead to hyperinflation, where the value of money becomes so low that people can’t afford necessities. In this article, we will explore the pros and cons of compounding inflation and let you decide for yourself whether it is a good idea or not!
Two types of Inflation
There are two main types of inflation: demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when there is too much money chasing too few goods. This causes prices to go up and leads to inflation. On the other hand, cost-push inflation occurs when production costs go up, which is passed on to consumers in the form of higher prices. So, inflation can be caused by either too much money chasing too few goods or by an increase in costs of production.
Effects of Inflation
Inflation is a “general increase in the prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money” [Source]. It involves money or currency losing its buying power, and consumers also fail to buy their goods or acquire services due to the high prices experienced. Inflation is a gateway to poverty, especially for low-income earners, and only those with deep pockets may survive an inflation environment.
Dire effects of inflation include the closure of business and service delivery facilities, ranging from council cities to government departments. A whole locality will be affected when a currency loses its power, and the economy will run dry. Economists believe that inflation might be favorable only to a certain extent, but hyperinflation causes many problems for customers and business players.
What is Compounding Inflation?
Compounding inflation is inflation that occurs over time. The calculation starts with the price level from a base year and then calculates the rate of inflation based on the current price and the time period since the base year. In other words, it’s an inflation rate that builds on itself. Compounding inflation can have dire consequences because prices are constantly increasing, and people’s money is worth less and less over time. This can lead to hyperinflation, as we mentioned before, and it can be a very difficult situation to recover from.
What are the Pros and Cons of Compounding Inflation?
The main advantage of compounding inflation is that it allows countries to print more money without affecting the value of their currency. This is because the prices of goods and services are constantly increasing, so the extra money printed does not cause inflation. This can be a helpful tool for governments in times of economic recession, as it can help stimulate the economy.
Another advantage of compounding inflation is that it can help reduce debt levels. This is because, as prices increase, the value of debt decreases. So, if a country has a lot of debt, then inflation can help reduce the level of debt relative to the size of the economy.
The main disadvantage of compounding inflation is that it can lead to hyperinflation, as we mentioned before. This can be a very difficult situation to recover from, and it can devastate an economy.
Another disadvantage of compounding inflation is that it can erode people’s savings. This is because, as prices increase, the value of savings decreases. So, if people have their money saved in cash, they will see their savings’ purchasing power decline over time.
Is inflation Compounding?
The shared view is that inflation is compounding. Inflation is usually measured on a yearly basis, and this is when economists can report on the changes in demand, consumption, and supply. Inflation is calculated as year-to-year growth rates of prices because it is based on the increment of prices of goods and services. “So, if prices rise 10% in the first year and stay that high the next year, in the second year, inflation is 0%”. To show that inflation is compounding, an inflation rate can be calculated. For example, a 2,44% yearly inflation can be worked out in a two-year period by multiplying it by 2,44% [Source]. This means that 2,44 is multiplied by 2,44, but one must change these values into a multiplication factor, and this is done by dividing 2,44% with 100 to get 1,0244. After this, multiply 1,0244 by 1,0244 to get 1,0494, which is rounded off to the same number of digits. This answer should be converted back to a percentage by subtracting one and multiplying it by 100, and the result of the two-year inflation will be 4,94%, proving that inflation is compounding.
Analysts argue that inflation must be compounded because there is no “starting” year where money was first given value. When applying 2% interest, this is done to the value of a dollar at its value when the interest was taken. It is also possible to take the inflation rate averaged over a period of years”.
