Inflation: definition and causes

In a market economy, the prices of goods and services can change at any time depending on supply and demand. Inflation is defined as a general increase in the overall price of goods and services over an extended period.

In the euro area, three main factors can cause the inflation to rise:

• Inflation via costs: when commodity prices rise, this drives up firms’ production costs, causing them to increase their product prices to protect their profit margins.
• Inflation via demand: this is when there is an excessive rise in demand for a limited supply of goods and services.
• Imported inflation: this is when prices rise due to a sustained fall in the euro exchange rate against other currencies. The cost of imported goods increases, which in turn pushes up prices.

A fourth possible cause of inflation, which is more harmful for the economy, is the monetary financing of public spending (sometimes called money printing). This is prohibited under the treaty creating the euro as it is likely to cause hyperinflation – defined as a rapid and unrestrained increase in prices.

In all three cases cited above, once prices start rising, if the central bank does nothing to alter inflation expectations, inflation can become entrenched. Central bank action is sufficient to stop the inflation rate from rising and bring it back down to 2%.

Why do we need to measure inflation?

It is important to measure inflation reliably. Anticipating future inflation rates gives individuals and firms an idea of what economic conditions to expect when implementing long-term projects.

Inflation is measured as the change in the prices of a set of goods and services that are representative of household consumption and the average shopping basket for the previous year. In France, the national statistics office (Institut National de la Statistique et des Etudes Economiques or INSEE) calculates the consumer price index (CPI) and the Harmonised Index of Consumer Prices (HICP). 

The HICP is harmonised in that it is calculated according to the same rules in all euro area countries. The main way in which it differs from the CPI is that it is calculated using a shopping basket that is more similar to actual consumer spending, i.e. after deduction of social security reimbursements. As a result, spending on health care carries a lower weight in the HICP, and the relative weights of other consumption items, such as energy, are higher. 

The European statistics office, Eurostat, uses the HICP to calculate the euro area inflation rate. It therefore determines the region’s monetary policy.

Why is it important to keep inflation at a moderate rate?

Keeping inflation at a moderate rate (2%) is good for the economy because:

• it provides a clear target on which everyone can base their long-term projects or investments
• by preventing inflationary or deflationary spirals, it gives the different sectors of the economy time to adjust their prices to their costs
• it allows households and firms to borrow at attractive interest rates as the central bank is not forced to tighten credit conditions by raising its policy rates

Inflation that remains above 2% for a prolonged period is harmful for the economy because:

• it erodes purchasing power, forcing households to lower their consumption and use their savings to maintain their living standards
• it increases inequality, as not everyone can protect themselves equally from inflation by increasing their income
• it can make domestic firms less cost-competitive than their foreign peers, causing a drop in sales and hence in economic activity
• it creates uncertainty and makes it difficult to predict how the economy will evolve in the future; this in turn makes it harder to take decisions about investments and consumption of durable goods

Deflation, which is a sustained and general fall in the overall price level, is very bad for the economy:

• it can lead to a deflationary spiral, as it encourages consumers to postpone their purchases for as long as possible, reducing economic activity
• it makes debt less sustainable as income and revenues fall in line with prices while the amount of debt stays the same.

What is the difference between inflation and purchasing power?

Inflation is a measure of the purchasing power of money. When inflation increases over an extended period, the purchasing power of money falls as the same amount in euro is worth less over time. 

An individual’s purchasing power is the quantity of goods and services they can buy with their income. It therefore depends both on the purchasing power of money and on fluctuations in their level of income. 

In a market economy, the change in purchasing power depends on inflation, but also on the volume of work and on average income per capita, after adding in social transfers and deducting taxes and social security contributions. In national accounting, the change in purchasing power is calculated as the difference between the change in household gross disposable income and the change in consumer prices.

Purchasing power therefore falls when inflation rises, but increases when unemployment falls as individuals who are in work have higher incomes than those not in work. In a market economy, income from labour follows the same trajectory, in average terms, as labour productivity.
 

How can we limit inflation?

To maintain price stability, the Banque de France helps to define and implement euro area monetary policy. There are two channels of monetary policy: the interest rate channel and statements on the central bank’s commitment to keep inflation at 2% over the medium term, which is known as the inflation expectations channel.

The first channel consists in making changes to policy or key rates, which are the interest rates at which the central bank lends to commercial banks.

If the central bank lowers its policy rates, commercial banks may also lower their lending rates. As loans are cheaper, households and firms have more incentive to borrow to finance their consumption and investments. This leads to higher demand for goods and services, placing upward pressure on prices. Conversely, if the central bank increases its policy rates, commercial banks will also increase their lending rates. Loans are therefore more expensive, causing demand to slow and inflation to moderate. 

The inflation expectations channel involves communicating on the state of the economy, which the central bank does by publishing quarterly economic projections. The Governing Council also publishes statements explaining how it is steering inflation back to 2% over the medium term. Full and simplified statements can be found on the European Central Bank website.