What is Inflation in Simple Terms: Causes of Price Increases and Protection Against It
Introduction
Inflation is a sustained increase in the general price level of goods and services in an economy, which leads to a decrease in the purchasing power of money. Simply put, this means that over time, the same amount of money can buy fewer goods than it could in the past. This phenomenon affects everyone: from a pensioner who notices rising food prices to an entrepreneur planning a business for several years ahead.
Understanding the mechanisms of inflation is critically important in today’s world, where economic processes are becoming increasingly interconnected. Events in one country can instantly affect prices in another: the COVID-19 pandemic demonstrated how supply chain disruptions can lead to price increases for food and goods worldwide. Geopolitical conflicts influence the cost of energy resources, which reflects on the prices of all other goods.
In this article, we will examine what inflation is, the factors that cause it, how it affects people’s daily lives and the economy as a whole, and we will propose practical strategies to protect savings and income from the devaluation of money.
What is Inflation: Definition and Key Characteristics
The term "inflation" comes from the Latin word "inflatio," which means "to swell." This accurately reflects the essence of the process: when prices rise, there is a kind of "swelling" in the value of goods and services. It is important to understand that inflation is not a one-time spike in prices for individual goods, but a sustained trend of rising overall price levels in the economy.
Inflation is measured using the Consumer Price Index, which tracks the change in the cost of a basket of goods and services typical for an average household. This basket includes food, clothing, housing, transportation, medical services, education, and entertainment. When statistical agencies report an inflation rate of 5%, it means that the basket of goods that cost 100 conditional units a year ago now costs 105 units.
The key distinction between inflation and ordinary price fluctuations lies in its systemic nature and duration. The price of gasoline may rise due to an accident at an oil refinery, but that is not inflation. Inflation occurs when prices rise month after month across most goods and services due to fundamental imbalances in the economy.
The opposite of inflation is deflation, where the overall price level decreases. Although at first glance deflation may seem beneficial for consumers, it often signals serious issues in the economy: a decline in demand, an increase in unemployment, and a drop in household incomes.
Types of Inflation: Classification by Various Criteria
Economists distinguish several types of inflation based on the rate of price growth, causes of occurrence, manifestations, and predictability.
Classification by Rate of Growth
Creeping inflation is characterised by a price increase of up to 10% per year. Such rates are considered normal for developing economies and even beneficial, as they stimulate consumption and investment. People understand that goods may become more expensive tomorrow, so they do not postpone purchases. Businesses receive incentives to expand production.
Galloping inflation involves a price increase of between 10% and 50% per year. At such rates, serious problems begin: the population loses trust in the national currency, enterprises struggle with planning, and banks are reluctant to issue long-term loans. The economy begins to operate in a mode of constant adjustment to changing prices.
Hyperinflation is a catastrophic price increase exceeding 50% per month or 100% per year. In a hyperinflationary environment, money loses its fundamental functions: people try to get rid of cash as quickly as possible, turning to barter or foreign currency. A classic example is Germany in the 1920s, where prices doubled every few days.
Classification by Causes of Occurrence
Demand-pull inflation occurs when total demand in the economy exceeds the supply of goods and services. Imagine a situation where the government raises salaries for public employees, pensions, and social benefits. People have more money to spend, but the quantity of goods in stores remains the same. The result is predictable—prices will start to rise.
Cost-push inflation develops when production costs for goods and services increase. The reasons can vary: rising raw material prices, energy costs, salary increases, or rising taxes and duties. Producers are forced to raise prices to maintain profitability. This type of inflation is particularly painful, as it is combined with slowing economic growth.
Structural inflation is typical for developing countries with unbalanced economies. Certain sectors grow faster than others, creating imbalances. For example, a mining industry may be rapidly growing while agriculture lags behind. As a result, food prices increase faster than those of other goods.
Imported inflation arises from rising prices of imported goods. If a country relies on imports for energy sources, raw materials, or finished products, any external shocks—from currency fluctuations to trade wars—are immediately reflected in domestic prices.
Open and Hidden Inflation
Open inflation manifests as free price increases in a market economy. People see how goods become more expensive and can adapt: seeking cheaper alternatives, changing consumption patterns, and demanding salary increases.
Hidden inflation occurs under administrative price controls. The government freezes prices on socially significant goods, but the excess money in the economy does not disappear. The result is total shortages, queues, a decrease in product quality, and the development of a black market. Such situations were characteristic of planned economies in socialist countries.
Causes of Inflation: Factors Behind Price Growth in Today’s Economy
Understanding the causes of inflation helps not only economists devise anti-inflation measures but also ordinary people better plan their finances and anticipate possible price changes.
Monetary Factors
Excessive money supply is a classic cause of inflation, described by economist Milton Friedman in his famous phrase: "Inflation is always and everywhere a monetary phenomenon." When a central bank or government "prints" too much money, its purchasing power declines. More money begins to "chase" the same amount of goods, which naturally leads to price increases.
Low-interest rates stimulate lending and increase the amount of money in circulation. Banks more actively lend to businesses and individuals, companies invest in expanding production, and people buy more goods. Rising demand with unchanged supply pushes prices up.
Devaluation of the national currency makes imported goods more expensive in national currency. Given that modern economies are heavily integrated into global supply chains, the increase in import prices quickly spreads throughout the economy. Not only finished goods but also raw materials, components, and energy carriers become more expensive.
Structural Factors
Economic monopolisation allows large companies to dictate prices. When a few players dominate the market, they have the opportunity to coordinate their pricing policy. A lack of competition diminishes the incentives for improving efficiency and restraining price growth.
Increasing government expenditure, especially if financed by money issuance, creates additional demand in the economy. The government competes with the private sector for limited resources—labour, raw materials, and production capacity. This competition pushes prices higher.
Demographic changes also affect inflation. An aging population increases the demand for medical services and medications. Urbanisation enhances demand for housing in cities. Changes in lifestyle create demand for new goods and services.
Psychological Factors
Inflationary expectations play a particularly important role in the modern economy. If people expect prices to rise, they start behaving accordingly: speeding up purchases, demanding salary indexation, transferring savings into more stable assets. Businesses preemptively raise prices, fearing increased costs. A self-sustaining cycle of price growth ensues.
Media and social networks amplify the psychological impact of inflation. Reports of price increases for individual goods may create the impression of a general rise in the cost of living, even if statistically, inflation remains moderate. People begin to save and stockpile, which paradoxically may spur further price increases.
External Shocks
Pandemics, natural disasters, military conflicts, trade wars—these events can provoke inflationary spikes. COVID-19 demonstrated how quickly a global economy can encounter supply-side inflation: factories shut down, logistical chains were disrupted, and shortages of many goods emerged.
Changes in raw material prices, especially oil, affect inflation worldwide. Energy carriers are a basic component for the production and transportation of virtually all goods. When oil prices rise, the costs for energy, heating, and transport increase, ultimately reflecting on the prices of all goods and services.
Consequences of Inflation for the Economy and Population
The influence of inflation on the economy and society is ambiguous and depends on its pace, predictability, and duration. Moderate inflation can stimulate economic growth, while high inflation destroys economic ties and social stability.
Impact on the Economy
Moderate inflation often accompanies periods of economic growth. It signals healthy demand in the economy and stimulates entrepreneurial activity, as business people see opportunities to increase profits. Consumers do not postpone purchases, understanding that goods may become more expensive tomorrow.
However, high inflation creates serious problems for the economy. It complicates long-term planning, as enterprises cannot predict their future costs and revenues. Investments become riskier, especially long-term projects. Capital begins to flow from the manufacturing sector into speculative operations.
Inflation distorts price signals in the economy. Under normal circumstances, prices help determine which goods and services are in demand and where resources should be directed. During high inflation, it becomes difficult to distinguish between price increases due to increased demand and general price rises.
The banking system suffers particularly from inflation. The real value of issued loans declines, which may seem beneficial for borrowers. However, banks compensate for this by raising interest rates, making loans less accessible. Lending decreases, slowing down investment activity.
Social Consequences
Inflation impacts different segments of the population differently, often exacerbating social inequality. Those most affected are people with fixed incomes: pensioners, civil servants, and budgetary sector employees. Their incomes are indexed with a delay and not always in full, leading to a decrease in real purchasing power.
Inflation particularly strikes low-income families, who spend a large portion of their income on basic needs—food, housing, transport. These goods and services often rise in price faster than others. Wealthy individuals, on the other hand, can protect their savings by investing in real estate, stocks, currencies, or other assets whose prices rise with inflation.
The middle class finds itself in a dual position. On one hand, many middle-class individuals hold mortgage loans, the real value of which decreases during inflation. On the other hand, their savings, often kept in bank deposits, devalue if the interest rate does not cover inflation.
Inflation affects labour relations. Workers demand salary increases to compensate for rising prices. Trade unions become more active. Social tension rises, especially if the government does not take effective measures to combat inflation.
The psychological impact of inflation often exceeds its real economic consequences. People feel a decline in living standards, even if their real incomes remain stable. Constant price rises create an atmosphere of instability and uncertainty, influencing political sentiments within society.
Global Experience: Historical Examples of Inflation
Economic history has known many examples of both moderate inflation promoting growth and catastrophic hyperinflation destroying entire countries.
The Great Inflation of the 1970s
In the 1970s, developed countries faced a phenomenon that economists termed stagflation—a combination of high inflation and economic stagnation. The oil crises of 1973 and 1979 spurred this trend, as oil prices surged multiple times.
In the US, inflation reached 13.5% in 1980. Traditional remedies proved ineffective: stimulating the economy led to even greater price increases, while curbing demand exacerbated the recession. It was only in the early 1980s that inflation was managed through severe measures by Federal Reserve Chairman Paul Volcker, who raised interest rates to a record 20%.
This experience altered approaches to monetary policy. Central banks gained greater independence and began to focus on long-term inflation goals rather than short-term employment support.
Hyperinflation in Weimar Germany
A classic example of destructive hyperinflation occurred in Germany between 1921 and 1923. After World War I, the country was obligated to pay large reparations. The government began printing money to finance expenditures.
By November 1923, prices were rising by 25% per day. A loaf of bread that cost 13 pfennigs in 1914 was worth 399 billion marks by the end of 1923. People were paid twice a day and spent their wages immediately. Money was transported in wheelbarrows and weighed rather than counted.
Hyperinflation was only halted by a radical monetary reform: old marks were exchanged for new ones at a ratio of trillion to one. This experience left a deep mark on German culture and explains the traditional German fear of inflation.
Modern Examples
Venezuela experienced one of the most severe hyperinflations in modern history during the 2010s. According to IMF estimates, inflation reached 1,000,000% in 2018, due to populist government policies, financing expenses via money issuance, falling oil prices, and international sanctions.
Zimbabwe also faced catastrophic inflation in the 2000s. Land reforms led to the collapse of agriculture, the backbone of the country's economy. The government printed money to finance the budget. By 2008, inflation had reached astronomical figures—estimated at 231 million percent annually.
Turkey experienced a serious inflation crisis in 2021-2022 due to the unorthodox policies of President Erdogan, who pressured the central bank to lower interest rates despite rising prices. Inflation exceeded 80%, and the lira devalued several times.
How to Protect Your Savings from Inflation
Protection against inflation requires a comprehensive approach and an understanding of various financial instruments. There is no one-size-fits-all solution—an effective strategy depends on income levels, financial goals, risk tolerance, and the economic situation in the country.
Bank Deposits and Their Limitations
Traditional bank deposits are the simplest and most understandable method of preserving money, but they do not always protect against inflation. If the interest rate on the deposit is lower than the inflation rate, the real value of savings decreases.
For example, if inflation is 7% and the deposit rate is 5%, the real yield is negative and amounts to -2%. After one year, the purchasing power of your money will decrease by 2%.
However, deposits have significant advantages: they are guaranteed by the government (usually up to a certain amount), easily accessible, and do not require special knowledge. For some of your savings, especially as an emergency fund, deposits remain a sensible choice.
When choosing a deposit, pay attention not only to the interest rate but also to the terms: the possibility of topping up, partial withdrawals, and interest capitalisation. During periods of high inflation, short-term deposits are preferable, allowing for rapid responses to changes in rates.
Investments in Securities
Stocks historically provide good protection against inflation over the long term. Companies can raise prices for their goods and services in line with inflation, which reflects in profitability and stock value.
Stocks of companies with strong brands and market power are particularly good at protecting against inflation. Such companies can raise prices without substantial loss of customers. Examples include producers of essential goods, utility companies, and pharmaceutical giants.
Inflation-linked bonds are specifically designed to protect against rising prices. In the United States, these are TIPS (Treasury Inflation-Protected Securities), with analogous instruments available in other countries. The par value of such bonds is indexed according to the official inflation rate.
Corporate bonds with variable interest rates can also offer protection since coupon payments automatically adjust with changing interest rates in the economy.
Investing in Real Assets
Real estate is traditionally regarded as a good hedge against inflation. Property values generally rise along with the overall price level, and rental rates can be indexed according to inflation.
However, real estate carries its risks: low liquidity, high transaction costs, and the necessity of management. An alternative could be investing in REITs (real estate investment trusts) that trade on exchanges like stocks.
Precious metals, especially gold, are frequently seen as a safe haven against inflation. Historically, gold has maintained its purchasing power in the long term, although its price may fluctuate significantly in the short term.
Commodities can also serve as a hedge against inflation, as their prices often rise faster than the overall inflation rate. Investing in commodities can be done through specialised funds or futures contracts.
Currency Diversification
Holding part of your savings in stable foreign currencies can protect against inflation, especially if it is caused by the devaluation of the national currency. The US dollar, euro, and Swiss franc are traditionally considered reliable currencies.
However, currency investments carry their risks: exchange rate fluctuations, political risks, and currency legislation limitations. In some countries, purchasing foreign currency is restricted or subject to additional taxes.
A more modern approach is investing in ETFs that track indices in developed countries. This allows for exposure to foreign assets and currencies while diversifying risks.
Investing in Personal Development
One of the best ways to protect against inflation is to invest in one’s own knowledge and skills. Education, professional training, and the development of new competencies enhance the ability to earn and adapt to changing conditions.
Unlike financial assets, human capital cannot be devalued or stolen. Skilled professionals typically can demand salary raises in line with inflation or change jobs for better-paying opportunities.
Practical Tips for Protecting Against Inflation
Effectively protecting against inflation requires not only the right choice of financial instruments but also changes to everyday habits and approaches to money management.
Reviewing Budgets and Expenses
In times of rising prices, it is particularly important to plan expenses carefully. Keeping a detailed budget helps identify unnecessary spending and find opportunities to save. Many people are surprised to discover how much they spend on minor daily purchases.
Optimising expenses does not mean forgoing all pleasures. It is about a reasonable approach: buying quality goods that will last longer, seeking discounts and promotions, comparing prices in different stores, and utilising loyalty programmes.
During high inflation, it is wise to accelerate large purchases, especially for durable goods. A refrigerator or a car purchased today could cost significantly more tomorrow.
Managing Debts
Inflation affects different types of debts in different ways. Fixed-rate loans become more advantageous for borrowers, as the real value of the debt declines. However, variable-rate loans may become more expensive if the central bank raises the base rate to combat inflation.
In periods of high inflation, it is advisable to avoid new consumer loans, especially for items that quickly depreciate. It is better to save money and purchase goods outright.
Fixed-rate mortgage loans during inflation can turn out to be a lucrative investment, as property values typically rise faster than inflation, while the real value of the debt decreases.
Creating a Financial Safety Net
A cash reserve for 6-12 months’ worth of expenses is particularly important amid economic instability. This reserve should be easily accessible, so it is best held in short-term deposits or highly liquid instruments.
The size of the safety net should be regularly reviewed in light of inflation. If a year ago, 100,000 rubles were necessary for living, then at a 10% inflation rate, you would now need 110,000 rubles.
Diversification and Regular Monitoring
Do not rely on a single method of protection against inflation. An effective strategy involves distributing funds across different assets: partly in bank deposits for liquidity, partly in stocks for growth, and partly in real estate or gold for stability.
The ratio of various assets should align with your goals, time horizon, and risk appetite. Young individuals may adopt a more aggressive strategy with a higher share of stocks, while older individuals may prefer a more conservative approach.
It is important to regularly review your investment portfolio. Changes in the economic environment may require adjustments to your strategy. What worked well during periods of low inflation may be ineffective under conditions of rising inflation.
The Role of Central Banks in Combatting Inflation
Central banks play a key role in maintaining price stability. Most modern central banks have a mandate to keep inflation at around 2-3% per year, which is deemed optimal for economic growth.
Monetary Policy Instruments
The primary tool for combating inflation is the interest rate. By raising the base rate, the central bank makes borrowing more expensive, which curbs consumption and investment. Reduced economic activity leads to slower price growth.
However, monetary policy is a double-edged sword. Excessively aggressive rate hikes can result in recession and increased unemployment. Central banks aim to strike a balance between controlling inflation and supporting economic growth.
Open market operations enable the central bank to influence the money supply. By selling government bonds, the central bank removes money from circulation, while buying adds money to the system. This affects the liquidity of the banking system and interest rates.
Reserve requirements dictate what portion of deposits banks must hold at the central bank. Increasing reserve requirements limits banks’ lending capabilities, which helps control inflation.
Communication Policy
Modern central banks place considerable emphasis on communication with the public. Statements from bank leaders, inflation forecasts, and policy explanations help shape inflation expectations.
If the public and businesses believe in the central bank’s ability to control inflation, this alone helps to contain price increases. Consumers do not rush to make panic purchases, and businesses are not eager to raise prices.
Limitations of Monetary Policy
Central banks are not omnipotent in combatting inflation. If price growth is caused by external shocks—such as rising oil prices, supply chain disruptions, or natural disasters—monetary policy may prove ineffective.
Structural problems within the economy—monopolies, government inefficiencies, corruption—also constrain central banks’ capabilities. In such cases, deeper reforms are needed.
Conclusion
Inflation is an inevitable companion of modern market economies, demanding understanding and active management of personal finances. While it is impossible to fully protect oneself from inflation, a sound approach can minimise its negative impact on wealth.
The key to success is diversifying protective strategies, continuous learning, and adapting to changing conditions. Inflation affects all aspects of financial life: from daily purchases to long-term investments. Understanding these mechanisms aids in making informed decisions and maintaining financial stability, even during periods of economic turbulence.
The modern world is characterised by high interconnectedness of economies, meaning that events in one country can swiftly influence inflation in others. The COVID-19 pandemic, geopolitical conflicts, and climate change—all these factors pose new challenges to maintaining price stability.
Remember: the best defence against inflation is knowledge, planning, and timely action. Start small by maintaining a budget, creating a financial safety net, and exploring available investment tools. Gradually enhance your financial literacy and do not hesitate to employ various methods to preserve and grow your capital.
Inflation is not only an economic phenomenon but also a social challenge that demands responsible approaches from government institutions as well as from each individual. Understanding the nature of inflation and ways to protect against it is becoming an important part of the financial literacy of modern individuals.
