What is Inflation?
When you find out to your dismay that your favourite chicken rice hawker is going to raise prices by 50 cents from tomorrow, your first reaction may be to utter the “i”-word.
This must be inflation, you exclaim.
But is it? As with any question in economics, the answer, according to economists like Harvard Kennedy School’s Dani Rodrik , is: it depends.
If the price of your favourite chicken rice increased because the hawker stall had just been awarded a Michelin Bib Gourmand award, chances are that only the price of this particular item will increase, due to its sudden popularity. This is not inflation.
Economists define inflation as a general increase in the overall price level of goods and services across the economy. If there is an increase in prices of chicken rice across most stalls in Singapore, as well as in the prices of many other goods and services, from groceries to phones, clothes, healthcare and so on, then this is indeed inflation. As a result, each Singapore dollar will not buy you as much tomorrow as it does today.
The inflation rate tells us how quickly the price level is changing.
Prices tend to rise over time as an economy grows. When inflation is low and stable, price changes are not large or volatile enough to affect the economic decisions made by households and businesses. Price stability—that is, having low and stable inflation over time—is a sign of a healthy economy.
When inflation is too high, it erodes the purchasing power of households whose incomes may not grow at the same pace. Businesses will also have to buy goods and services at higher prices, and the uncertainty around their costs makes it difficult for them to plan investments, which reduces economic growth. This is why central banks, like MAS, are focused on keeping inflation rates low and stable.
So, what causes inflation?
Economists often describe inflation as the result of “too much money chasing too few goods”. When there is more money in the economy than there are goods and services available for purchase, prices—which represent the amount of money needed to exchange for a good or a service—increases. In other words, the value of money—what each dollar can purchase—is eroded.
Inflation therefore occurs when demand for goods and services across the economy exceeds supply. There are two main reasons why supply and demand may not match:
Economists often describe inflation as the result of “too much money chasing too few goods”. When there is more money in the economy than there are goods and services available for purchase, prices—which represent the amount of money needed to exchange for a good or a service—increases. In other words, the value of money—what each dollar can purchase—is eroded.
Inflation therefore occurs when demand for goods and services across the economy exceeds supply. There are two main reasons why supply and demand may not match:
- rising production costs or a reduced availability of inputs used to produce goods and services, that lower the economy’s supply of goods and services (aggregate supply); and
- greater demand for goods and services across the economy (aggregate demand).
Let’s look at these in more detail.
Cost-Push Inflation
Demand-Pull Inflation
Cost-push inflation
Imagine that global food prices rise sharply due to weather events that lower crop yields. Wet markets, supermarkets and many hospitality-related businesses in Singapore are heavily reliant on imported food, which has now become more expensive or less available.
To cope with higher costs, supermarkets may reduce their stocks or decrease the variety of products offered. Restaurants may drop some items from their menus. In other words, aggregate supply in the economy will decrease.
However, if aggregate demand does not change, there will be a shortage of supply relative to demand. The higher production costs that businesses are facing will also be passed on to consumers as higher prices. This results in cost-push inflation.
Demand-pull inflation
Suppose the economy is growing strongly and businesses are profitable. To reward and retain their workers, firms give out good bonuses and pay raises. This boosts consumer spending and lifts aggregate demand in the economy.
If aggregate supply does not change, there will be an excess of demand relative to supply.
In these situations, businesses across the economy are likely to increase prices in tandem, as strong demand means buyers are willing and able to pay more for goods and services that are in short supply. This is called demand-pull inflation.
Imagine that global food prices rise sharply due to weather events that lower crop yields. Wet markets, supermarkets and many hospitality-related businesses in Singapore are heavily reliant on imported food, which has now become more expensive or less available.
To cope with higher costs, supermarkets may reduce their stocks or decrease the variety of products offered. Restaurants may drop some items from their menus. In other words, aggregate supply in the economy will decrease.
However, if aggregate demand does not change, there will be a shortage of supply relative to demand. The higher production costs that businesses are facing will also be passed on to consumers as higher prices. This results in cost-push inflation.
Demand-pull inflation
Suppose the economy is growing strongly and businesses are profitable. To reward and retain their workers, firms give out good bonuses and pay raises. This boosts consumer spending and lifts aggregate demand in the economy.
If aggregate supply does not change, there will be an excess of demand relative to supply.
In these situations, businesses across the economy are likely to increase prices in tandem, as strong demand means buyers are willing and able to pay more for goods and services that are in short supply. This is called demand-pull inflation.
In the next article, we will look at how severe demand and supply mismatches developed during and after the COVID-19 pandemic and led to high inflation in 2022.
To review what inflation is, watch this video.