The value of money and inflation

Inflation and Deflation

As soon as we get our own money to spend, we start to observe that some goods and services become cheaper over time while others become more expensive. In a market economy, price fluctuations like that are not unusual. How much individual goods or services cost depends on a number of factors. Even our tastes and preferences, for example, have an influence on supply and demand.

When some goods and services become more expensive, this does not mean that prices in a given country will rise in general. We only talk about inflation when the prices of many goods and services rise over a longer period of time. Since higher prices mean that you can buy less for your money, inflation means a general loss of purchasing power: The value of money is falling. The opposite of inflation is deflation. Deflation means that prices go down in general and the value of money goes up. Deflation means that a family, for instance, will be able to buy more goods and services for the same amount of money than before.

Effects of inflation and deflation

Both high inflation and deflation pose problems to economies such as Austria or economic areas such as the European Union (EU). In times of high inflation, for example, the real value of savings declines if the agreed interest rates are lower than inflation. When inflation is high, the general level of interest rates tends to be raised. This also increases the interest that has to be paid on loans. With interest costs for loans rising, making investments (i.e. buying consumer or capital goods) also becomes more expensive in times of high inflation. This means people buy fewer consumer and capital goods. As a consequence, economic growth stagnates (see also Money and its price (interest)). When inflation rates are very high, exceeding 50%, we speak of hyperinflation. If this extreme form of inflation occurs, people lose confidence in the currency.

When deflation occurs, prices go down. That’s why at first glance, deflation appears to be good for consumers and companies alike: For the same amount of money, they can buy more goods than before. For an economy, however, deflation has many negative effects. When people and companies assume that prices will fall, they tend to wait before buying the things they want, hoping that they will become even cheaper. As a result, demand for goods and services goes down and and companies reduce the prices of their products even further. This puts a brake on economic growth in the medium term. Moreover, jobs are lost because companies produce fewer goods. This, in turn, means that many consumers have less many to spend on buying goods. Declining demand then forces companies to produce even fewer goods and lower their prices. This vicious circle is called “deflationary spiral.” It is just as bad for the economy as excessive inflation.

The role of central banks

For economies to be stable in the long run, the currency in the economic area they belong to must be as stable as possible. After all, exchange transactions in an economy only work well if all participants (the so-called economic agents) are confident that the money they have today will still be worth about the same tomorrow. Making sure the currency remains stable is the task of central banks. Central banks work to keep the currency as stable as possible by taking monetary policy measures.

Before the euro was introduced, the national central banks of the euro area countries took the monetary policy decisions for their respective countries. Since the euro was introduced, the European System of Central Banks (ESCB) has been responsible for ensuring price stability in the euro area. The ESCB consists of the European Central Bank (ECB), which is located in Frankfurt am Main, Germany, and the national central banks of all 27 European Union member states. The Eurosystem consists of the ECB and the 20 national central banks of those EU countries whose common currency is the euro. The Oesterreichische Nationalbank (OeNB) represents Austria both in the ESCB and in the Eurosystem.

The ECB's main objective is to maintain price stability in the euro area. Other objectives are to support the general economic policies in the EU and to promote the smooth operation of payment systems in the euro area. The ECB defines price stability as an inflation rate of 2% over the medium term.

You might wonder why the ECB does not aim for an inflation rate of 0% if its goal is to keep prices as stable as possible. This is because a low inflation rate of around 2% helps prevent deflationary spirals, which pose major problems for any economic area. Prolonged periods of deflation often cause an economic downturn (recession). And a recession, in turn, can result in the loss of many jobs (deflationary spiral). Moreover, the small losses in purchasing power resulting from an inflation rate of around 2% still help promote economic growth. Actually, a low level of inflation is even good for an economic area as people are more willing to spend their money if they see that its value is declining slightly over time.

How can the ECB influence price stability? The ECB's monetary policy focuses on controlling and managing the money stock and supplying the euro area with money. There are many factors the ECB has to take into account in its monetary policy decisions. The ECB not only monitors the money stock but also economic developments in the euro area and worldwide. It aims to keep the money stock in line with the quantity of goods available in the market. Inflation occurs when there is an excessive increase in the money stock in relation to the quantity of goods (see also Money as a means of exchange). The money stock and overall demand in the economy are strongly influenced by the monetary policy of an economic area. When the ECB lowers its key interest rates, commercial banks will follow suit, which means taking out loans becomes cheaper for companies and households. If companies and households take out more loans, the stock of money increases. This means that more money can be used for investments and consumption. This, in turn, drives up demand. (For more information on how the ECB uses key interest rates to make monetary policy and control the money stock, see Money and its price (interest)).

Causes and types of inflation

Inflation is caused by an imbalance between the quantity of goods and services available in an economic area (i.e. the supply of goods and services) and the demand there is for these goods and services. If overall supply in an economy is in balance with overall demand, prices remain stable. If the money stock increases and, as a result, households and companies have more money to spend, demand will usually rise. The causes of inflation can be found both on the demand side or the supply side.

The following figure gives an overview of the different types of inflation.

Supply-side inflation: Supply-side inflation occurs when companies raise the prices of their products. There are many reasons why companies may do so, e.g. if they cannot offer as many products as usual because of problems along the supply chain or production downtimes. If demand for these products remains the same, however, companies can charge higher prices for them. Moreover, when companies face higher costs for personnel, energy and raw materials, they tend to pass these on to customers by raising the prices of their products. This phenomenon is called cost-pressure inflation.

Wage negotiations, in particular, are a key factor in this context. Wages and salaries are generally a major cost item for companies, but there are many other factors that may also influence how companies set the prices of their products. When higher wages and salaries are agreed in wage negotiations, companies will pass on at least some of their higher personnel costs to their customers by raising the prices of their products. Price increases, in turn, cause employees to demand higher wages and salaries as they, too, have to deal with higher costs in times of high inflation. When employees have more money available to buy goods, companies believe that they will spend this money on their products and often react by raising their prices even further to maintain their profit margins. Employees, in turn, react to these higher prices by demanding yet higher wages to compensate for their own increased costs. So both sides, companies and employees, have to deal with higher costs. The dynamics arising from this situation cause wage and price levels to drive each other up. This is called an inflationary spiral.

Rising energy prices also boost inflation, as every industry and every household is dependent on energy. It is difficult to reduce energy consumption or switch to other sources of energy when prices of major energy sources such as electricity or gas go up.

Finally, if companies hold an advantageous market position, they may also raise their prices to maximize their profits (profit inflation). This happens in particular when there are few suppliers and there is therefore little competition in a market. To prevent companies from charging any price they want, the government must ensure that no cartels (price agreements between companies) are created and that there are always enough suppliers in a market.

Demand-side inflation: Inflation can be caused by an increase in demand, e.g. if demand from households rises (consumer inflation) and/or if companies or the government make more investments (investment-driven inflation). Companies usually need some time to expand their production to meet rising demand, or they may find it impossible to expand production due to a shortage of resources or supply problems. If this is the case, overall supply in the economy is smaller than overall demand. As a result, the prices for goods and services go up.

This happened, for instance, after the COVID-19 pandemic was over. During the pandemic, many people did not spend their money but saved it. Companies were cautious, too, postponing their investments as no one knew how and when the pandemic would end. Once pandemic-related restrictions were eased, demand significantly increased again. While households primarily turned back to buying more consumer goods, booking trips or going out, companies turned to making more investments again. This caused prices to go up.