What are inflation, stagflation and deflation?

“Inflation” is one of those terms that you seem to stumble upon almost everywhere, but it's never quite clear what it means and how inflation affects you. Today, we are going to try to offer you the simplest and most understandable explanation for this term as well as for the terms “stagflation” and “deflation” on top. To learn about inflation in even more detail, check out our Bitpanda Academy.

What is inflation simply explained?

The term “inflation” sounds complicated, but in fact we all actually experience the effects of inflation in our everyday lives. Let’s say you go to the supermarket every week to do your grocery shopping and have a budget of EUR 70 for your shopping. More or less, you always put the same things in your shopping cart: soy milk, avocados, toilet paper are three of them, among other items.

At the check-out, you discover to your dismay that you won’t be able to get by with your EUR 70 for this week’s grocery haul - you need to pay more. Why? Inflation has struck and this means you have to spend more to buy the same amount of goods. In technical terms: inflation means a decrease in the purchasing power of your money.

In a nutshell: the phenomenon of inflation changes the ratio between money and goods or services. Inflation indicates that the general price level is rising. You need more money to get the same amount of a good or service, or you get a decreased amount of a good or service for the same amount of money you had to spend before.

Economists use predefined shopping baskets, similar to an index, to measure inflation in an economy on an ongoing basis. Inflation is expressed as a percentage of the increase in the price level, for example a set basket of food items, over a set period of time (for example, one year). The European Central Bank deems an inflation target of 2% over the medium term as appropriate to ensure price stability.

What is an example of inflation?

Let's look at your soy milk. Why has it suddenly become more expensive? There could be several reasons for this. One of them is based on the “demand-pull inflation theory”, for example - a price increase that occurs if a very high number of other consumers also suddenly discover that they enjoy drinking soy milk. The demand for soy milk then increases faster than manufacturers can produce to meet demand. So in this case, the price of soy milk goes up as well.

Alternatively, the costs of producing soy milk may have increased for soy milk manufacturers and so the company is forced to raise the price to make a profit from selling their product. Some of these costs for companies can include government taxes, labour wages, or cost increases for soya beans. Consequently, in this case, we refer to “cost pressure inflation”.

Can inflation also have positive effects?

According to economic theory, inflation occurs when money supply in an economy is greater than the demand for money. How does this happen? When a country's central bank sets low interest rates, regular commercial banks benefit from offering favourable loans. These loans are then taken out by companies to make investments.

For example, a company takes out a loan on favourable terms to build a new factory hall and commissions a construction company with the project. In turn, the construction company buys wood from a sawmill, which then orders new equipment from another company and so on. In other words, demand for goods is boosted and so is economic growth.

If an economy has a surplus of labour or resources that are unused, in theory, inflation contributes to increasing production on account of increasing demand. In other words, inflation is regarded as positive if it helps to stimulate consumer demand, consumption and, ultimately, economic growth.

Why is inflation “eating away” at my savings?

You have probably read over and over again that inflation is “eating away” at your savings in your savings account and that it is therefore no longer worth saving your money. This is not quite accurate. The reasoning behind such statements is that during times of low interest rates, you will only receive very low interest (if any at all) and consequently, compound interest on your savings, so it is definitely recommended that you do some research on basic investing and finance to learn how to generate profits from investments. Nevertheless, it is always an advantage if you build up an emergency savings fund for unexpected events.

What are deflation and stagflation?

When the inflation rate falls below 0%, deflation occurs. This means that there are more goods and services in a market than there are consumers, and that supply also exceeds demand. This high supply can be a result of overproduction, too much competition or a decline in money supply. Low demand leads to falling prices, which may trigger negative economic development. With the decreasing demand for goods and services, companies may have to lay off employees, which in turn reduces their purchasing power and so forth.

Also, please make sure you don’t confuse the term “deflation” with “disinflation”, which means a decline in rising price levels, or the term “reflation” which refers to stimulating an economy by increasing money supply or lowering taxes. Economists help to make sure that inflation and deflation remain in a healthy equilibrium.

Finally, let’s talk about “stagflation”, a term combining the words “inflation” and “stagnation”. An economy in stagflation has a high inflation rate and is marked by slow economic growth and persistently high unemployment, such as the period following the oil crisis in the 1970s.

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