How inflation works | CNBC Explains

CNBC International

16 Sept 202112:36

EducationalLearning

32 Likes 10 Comments

TLDRThis script explores the concept of inflation, explaining it as the rate of increase in the price of goods and services over time. It distinguishes between demand-pull and cost-push inflation, with the former occurring when demand outstrips supply, and the latter when business costs increase and are passed to consumers. The discussion also touches on Milton Friedman's monetary theory of inflation and the importance of transaction velocity. The Consumer Price Index (CPI) is highlighted as the key measure of inflation, with a focus on both headline and core inflation. The video balances the economic implications of inflation, noting its role in a healthy economy, the dangers of hyperinflation, and historical examples of inflation management, such as the actions of the U.S. Federal Reserve in the 1970s.

Takeaways

🏠 Inflation is a key reason why the cost of purchasing a home has increased significantly over time.
📈 Inflation is defined as the rate of increase in the price of goods and services over time.
🛍️ There are two main types of inflation: demand-pull inflation, which occurs when demand outpaces supply, and cost-push inflation, which happens when increased business costs are passed on to consumers.
🌐 Cost-push inflation can be triggered by events like natural disasters or supply chain bottlenecks that lead to higher production costs.
💰 Demand-pull inflation is often a sign of a strong economy where consumers have more disposable income and companies can't increase production to meet demand.
💵 Milton Friedman's theory suggests that inflation is primarily a monetary phenomenon, caused by an increase in the money supply.
🔍 The velocity of transactions is crucial for the money supply to have an inflationary effect; if the velocity drops, the impact on inflation is reduced.
📊 The Consumer Price Index (CPI) is the most widely used measure of inflation, reflecting the percentage change in the price of a typical household's basket of goods and services.
🧐 Core inflation, which excludes volatile components, is considered by some economists to be a more valuable metric than headline inflation.
👍 Moderate inflation is generally seen as a sign of a healthy economy, but hyperinflation, with rates over 50% per month, can be disastrous.
🏦 Central banks now have a primary mandate to monitor and control inflation, often targeting a rate around 2% to balance economic growth and stability.

Q & A

What is inflation and why does it occur?
-Inflation is the rate of increase in the price of goods and services over time. It occurs due to various factors such as demand-pull inflation, where demand outpaces supply, and cost-push inflation, where increased business expenses are passed on to customers.
Can you provide an example of cost-push inflation?
-Cost-push inflation can occur due to events like natural disasters that affect the price of raw materials. An example given in the script is the supply chain bottlenecks and increased shipping costs following the global lockdown, which led to higher manufacturing costs and, consequently, higher product prices.
What is demand-pull inflation and how does it relate to a strong economy?
-Demand-pull inflation happens when the demand for goods and services exceeds supply, often occurring when the economy is strong and operating close to full capacity. People may have more disposable income, leading to increased demand that companies, already operating at full capacity, cannot match with increased production, resulting in higher prices.
How does Milton Friedman's theory relate to inflation?
-Milton Friedman posited that inflation is primarily a monetary phenomenon, suggesting that an increase in the money supply leads to higher prices. However, the script points out that for this to be inflationary, the velocity of transactions must also increase.
What is the significance of the velocity of transactions in relation to inflation?
-The velocity of transactions refers to the rate at which money changes hands in the economy. According to the script, even if the money supply increases, if the velocity of transactions does not go up, the impact on inflation could be minimal.
What is the Consumer Price Index (CPI) and how is it used to measure inflation?
-The CPI is an economic indicator that measures the percentage change in the price of a basket of selected goods and services that a typical household uses over time. It is used to calculate the inflation rate seen in headlines by comparing the cost of the basket in different periods.
Why might different countries have different items in their CPI baskets?
-Each country constructs its own CPI basket to reflect the spending habits of its citizens. The items included in the basket are meant to represent what a typical consumer would spend on a month-to-month basis.
What is the difference between headline inflation and core inflation?
-Headline inflation is the overall inflation rate calculated using the CPI, including all components. Core inflation, on the other hand, excludes volatile components, such as oil prices, to provide a more stable measure of underlying inflation trends.
Why do economists consider a little bit of inflation to be good?
-Economists view a moderate level of inflation as a sign of a well-functioning, productive, and growing economy. It can stimulate spending and investment, as people are encouraged to purchase goods and services before prices rise further.
What is hyperinflation and how does it differ from regular inflation?
-Hyperinflation is a drastic economic phenomenon where prices spiral out of control, with inflation rates increasing by more than 50% per month. It is typically caused by excessive money supply and a loss of confidence in the economy or monetary system, and it differs from regular inflation by its extreme and destabilizing nature.
How did the U.S. Federal Reserve respond to high inflation in the 1970s and what were the consequences?
-In response to high inflation in the 1970s, then Fed Chair Paul Volcker implemented a series of interest rate hikes, eventually reaching 20 percentage points. This aggressive approach successfully reduced inflation to around 3% by the mid-1980s but resulted in a recession and high unemployment.
What changes have been made by countries to prevent a repeat of the inflation issues seen in the 1970s?
-Countries have established central banks with mandates to monitor and control inflation. The goal for many central banks in advanced economies is to keep inflation around 2%, avoiding both the secondary effects of high inflation and the risks of deflation or disinflation.

Outlines

00:00

📈 Understanding Inflation and Its Causes

This paragraph delves into the concept of inflation, which is the increase in the price of goods and services over time. It highlights two primary causes: demand-pull inflation, where demand outstrips supply, often during strong economic periods, and cost-push inflation, which occurs when businesses pass on increased costs to consumers, possibly due to events like natural disasters or supply chain issues. The paragraph also introduces the monetary theory of inflation by Milton Friedman, suggesting that inflation is primarily a result of an increased money supply. However, it notes that simply increasing the money supply isn't enough to cause inflation; the velocity of money, or the rate at which money is exchanged in transactions, must also increase.

05:04

📊 The Role of the Consumer Price Index (CPI) in Measuring Inflation

This section explains how inflation is measured using the Consumer Price Index (CPI), an economic indicator that tracks the percentage change in the cost of a typical household's basket of goods and services. The CPI basket varies by country and is designed to reflect the spending habits of consumers. Economists calculate the CPI by comparing the cost of the current basket to that of a previous period, which helps determine the headline inflation rate. The paragraph also discusses core inflation, which excludes volatile components to provide a more accurate measure of long-term price trends. It emphasizes the importance of a moderate inflation rate for a healthy economy but warns of the dangers of hyperinflation, where prices can increase uncontrollably, as seen in historical examples like Brazil and the Weimar Republic in Germany.

10:07

🛠 Historical Perspectives on Inflation and Central Banks' Responses

The final paragraph discusses the historical context of inflation, particularly focusing on the 1970s when many developed economies experienced double-digit inflation rates. It describes the 'wage spiral' that occurred as workers demanded higher pay due to rising costs of living. The paragraph highlights the response of then Federal Reserve Chairman Paul Volcker, who aggressively increased interest rates to combat inflation, eventually reducing it to a more manageable level but at the cost of a severe economic recession and high unemployment. The paragraph concludes by examining the changes made by countries and central banks to prevent a recurrence of such economic turmoil, emphasizing the role of central banks in maintaining price stability and targeting an inflation rate of around 2% to avoid both inflationary and deflationary pressures.

Mindmap

Keywords

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. In the video, it is the central theme, with various examples illustrating its impact over time, such as the cost of a pint of milk in the UK increasing from three pence in 1960 to 50 Pence today. The video discusses different types of inflation and their implications on the economy.

💡Demand-pull Inflation

Demand-pull inflation occurs when the demand for goods and services exceeds supply, typically during strong economic periods. The video explains this concept by stating that when people feel they have more disposable income, the demand for goods and services increases. If companies are operating at full capacity, they cannot increase production to meet this demand, leading to higher prices.

💡Cost-push Inflation

Cost-push inflation happens when the costs to businesses increase and these additional costs are passed on to consumers, leading to a rise in the prices of goods and services. The script cites examples such as supply chain bottlenecks, increased shipping costs, and labor shortages post-lockdown, which contribute to higher input costs and, consequently, higher product prices.

💡Monetary Phenomenon

The term 'monetary phenomenon' as used in the video refers to the theory that inflation is primarily caused by an increase in the money supply. This view was famously posited by economist Milton Friedman, who argued that inflation is a result of too much money chasing too few goods. The video discusses this theory in the context of central banks' actions during financial crises and pandemics, which have increased the money supply.

💡Velocity of Transactions

Velocity of transactions is the frequency at which money changes hands in an economy. The video explains that for an increased money supply to cause inflation, the velocity of transactions must also increase. If money is not being spent, even a large money supply may not lead to inflation, as illustrated by the hypothetical bag of cash that no one picks up and spends.

💡Consumer Price Index (CPI)

The Consumer Price Index, or CPI, is an economic indicator that measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The video describes CPI as the most widely used measure of inflation, calculated by comparing the cost of a basket of goods and services over different time periods to determine the percentage change.

💡Headline Inflation

Headline inflation is the term used to describe the official inflation rate that includes all components of the CPI basket. The video explains that headline inflation is what is commonly reported in the media, but it may not always reflect the underlying economic trends due to the inclusion of volatile components.

💡Core Inflation

Core inflation is a measure of inflation that excludes volatile items such as food and energy prices to reflect the underlying trend of inflation in an economy. The video suggests that core inflation is a more valuable metric to follow because it smooths out short-term fluctuations and provides a clearer picture of the economy's strength.

💡Hyperinflation

Hyperinflation is a term used to describe a situation where the inflation rate is extremely high, typically more than 50% per month, causing prices to spiral out of control. The video provides historical examples, such as Brazil and the Weimar Republic in Germany, where hyperinflation led to a significant loss of purchasing power and economic instability.

💡Interest Rates

Interest rates are the cost of borrowing money and are used by central banks to control inflation. The video recounts the story of how the then Fed chair Paul Volcker increased interest rates to combat high inflation in the 1980s. This action, while successful in reducing inflation, came at the cost of a recession and high unemployment.

💡Central Banks

Central banks are institutions that manage a country's monetary policy and supply of money. The video emphasizes the role of central banks in maintaining price stability and preventing high inflation. It mentions that many central banks aim to keep inflation around 2%, which is considered a healthy level for a growing economy.

Highlights

Inflation is the rate of increase in the price of goods and services over time.

Demand-pull inflation occurs when demand for goods and services outpaces supply, often during a strong economy.

Cost-push inflation happens when business expenses increase and are passed on to customers.

Examples of cost-push inflation include supply chain bottlenecks and natural disasters affecting input costs.

Milton Friedman's theory posits that increasing money supply is a primary cause of inflation.

The velocity of transactions is crucial for the money supply to impact inflation.

Consumer Price Index (CPI) measures inflation by tracking the change in prices of a basket of goods and services.

Each country constructs its own CPI basket reflecting the spending habits of its citizens.

Headline inflation is calculated using the CPI, but core inflation excludes volatile components for a clearer trend.

Moderate inflation is seen as a sign of a healthy, growing economy.

Hyperinflation, with rates over 50% per month, is economically destructive and can be triggered by excessive money supply.

Historical examples of hyperinflation include Brazil and the Weimar Republic in Germany.

In the 1970s, the U.S. faced double-digit inflation due to energy supply shocks and wage spirals.

Paul Volcker, former Fed chair, managed to tame inflation by hiking interest rates to 20%, albeit with a recession as a cost.

Central banks now focus on keeping inflation around 2% to avoid both inflationary and deflationary issues.

Central banks' primary goal is to monitor and control inflation to ensure economic stability.

Economists agree that a little inflation is good, but too much can lead to severe economic consequences.

Transcripts

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Takeaways

Q & A

What is inflation and why does it occur?

Can you provide an example of cost-push inflation?

What is demand-pull inflation and how does it relate to a strong economy?

How does Milton Friedman's theory relate to inflation?

What is the significance of the velocity of transactions in relation to inflation?

What is the Consumer Price Index (CPI) and how is it used to measure inflation?

Why might different countries have different items in their CPI baskets?

What is the difference between headline inflation and core inflation?

Why do economists consider a little bit of inflation to be good?

What is hyperinflation and how does it differ from regular inflation?

How did the U.S. Federal Reserve respond to high inflation in the 1970s and what were the consequences?

What changes have been made by countries to prevent a repeat of the inflation issues seen in the 1970s?