Prices are an important indicator of how an economy is doing, and they have a huge impact on a country’s economic stability and the quality of life for its citizens. In this article, you’ll learn why inflation is important, how to determine it, and the importance of price stability.
Why inflation matters and how it’s calculated
Inflation is one of the most common economic news stories we read. The rise and fall of inflation is an economic phenomenon that hits close to home, and if you type the two words “inflation” into any news portal, you’ll see a lot of articles about it. Most of the time, the nuances are worrisome. “Inflation is at a multi-year high,” ‘Prices are rising due to rising oil prices,’ ‘Shopping for groceries has become scary as shopping cart prices have skyrocketed,’ and so on.
So why is inflation a problem? The simplest way to define inflation in one sentence is “the average price level of different goods and services. So why don’t we just look at whether prices have risen or fallen for each product, like ketchup for ketchup and squid for squid? Why do we need to calculate the price changes of so many products in the name of inflation? If we were to average the prices of all these different goods together, we would get an average that would be far from realistic.
Why do we care about inflation?
If you think about the purpose, you can see why we calculate inflation. The reason the government measures and publishes inflation every month is to track the overall trend in the price of goods. This is because they need to know whether the prices of goods and services are generally rising or falling so that they can react appropriately (such as making economic policies). Since the goal of measuring inflation is to identify the big picture, you can’t read the big picture by looking at the price changes of a few items.
This is one of the reasons why we use averages to measure inflation. For example, food, clothing, transportation, and gas are items that are consumed frequently in everyday life. On the other hand, things like cars, TVs, refrigerators, and washing machines are purchased once every few years, or even once every decade or so. Since the frequency of consumption varies greatly for different products, it is difficult to determine the price of a product using only a few products. Therefore, we use as many representative items as possible and weight them according to the average amount of money people spend on these products and services to find the price. First, the representative items are selected from goods and services that people consume a lot, and then calculated so that goods and services that people consume a lot and frequently have a greater impact on the price index.
For example, there are different types of price indexes published by the South Korean government, depending on which goods and services they mainly cover price changes, and who are the people who are mainly affected by the changes. There are three main types of price indexes: producer price indexes, which are based on the prices at which producers sell their goods and services; wholesale price indexes, which are based on the selling prices of first-tier wholesalers; and consumer price indexes, which are based on the prices at which consumers buy.
Among the various price indexes, the consumer price index is the most familiar and relevant statistic to the general public. It is released monthly by Statistics Korea, and is based on the price changes of goods and services in 458 representative items selected by Statistics Korea. The current 458 items on which the CPI is based were finalized at the end of 2020. The representative items are changed every five years to keep up with changing times. This is because consumer tastes and trends change over time. This leads to new items that need to be added to the list, and new items that need to be removed. By looking at the representative items that make up the Consumer Price Index, you can see at a glance how the consumption trends in Korean society have changed and how the average Korean’s consumption behavior has changed.
Every five years, the CPI is revised to reflect changes in consumption patterns over time. In the 2020 revision, the number of representative items was adjusted to 458 from 460 in 2015. The 2020 revision added 15 new items, including electric vehicles, masks, and clothes dryers, and removed 17 items, including ties, briquettes, and printers. Currently, the Consumer Price Index is based on prices in 2020, meaning that prices in 2020 are set at 100p to capture changes in prices.
There are several other price indexes published monthly by Statistics Korea. For example, the Consumer Price Index consists of 144 items that consumers frequently buy and spend a lot of money on, and the Fresh Food Index consists of only 50 fresh food items such as vegetables, fruits, and fish.
Why is price stability important?
Stabilizing prices is essential for a country’s economic development. If you look at history, countries in decline have a common trait: spikes in inflation. As far back as the end of the Roman Empire, inflation spiked, and as close to home as Germany after World War I, inflation spiked to murderous levels. The phenomenon of a steady increase in prices across the board due to an increase in the amount of money in circulation is called inflation, and the inflation that Germans experienced in 1923 is called “hyperinflation,” with the prefix “hyper” meaning “excessive or excessive” – in other words, “hyperinflation.
You only need to look at the fluctuations in the price of bread, a staple food, to see how severe Germany’s inflation was at the time. In 1918, a loaf of bread cost half a mark, and five years later, in 1923, it cost a whopping 100 billion marks. The exchange rate soared to 4 trillion marks to the dollar. Money was now worth less than the paper it was printed on. This extreme economic unrest sets the stage for the rise of the totalitarian Nazi regime.
Hyperinflation like this isn’t just for history books. More recently, the South American country of Venezuela has been suffering from extreme inflation. According to the International Monetary Fund (IMF), Venezuela’s inflation rate in 2017 was a whopping 4,300%. That’s a 43-fold increase in prices in just one year. In 2015, it was 112%, and in 2016, it was 2,800%, and it’s only gotten worse over time. But even 2017’s increase pales in comparison to 2018. In 2018, prices rose 1.69 million percent.
As prices skyrocket, the lives of Venezuelans are suffering. The average salary doesn’t even cover the cost of an egg. The rising cost of living has made it impossible to afford even food to put in your mouth. According to data released by the United Nations High Commissioner for Refugees (UNHCR) in November 2018, three million Venezuelans have fled the country since 2015. That’s one in 10 of the country’s citizens who have been displaced.
Why did Venezuela’s economy collapse to this point? Venezuela used to be an oil-producing country with huge oil reserves. The Venezuelan government used the money it earned from exporting oil to provide welfare benefits to its citizens. But when the price of crude oil plummeted in 2014, Venezuela’s economy, which had no other source of revenue than oil exports, quickly collapsed. The country’s failure to revise the welfare programs that were put in place during the high oil prices, even when it was clear that the price of crude was plummeting, is considered to be a major cause of its downfall. In 2017 alone, the average Venezuelan lost 10 kilograms in weight.
Without economic stability and prosperity, people can’t live happy lives. This historical lesson is why governments are focusing on price stability. South Korea’s central bank, the Bank of Korea, was founded with the banner of price stability. If you go to the Bank of Korea’s website, you’ll see that its mission statement is “The Bank of Korea contributes to the healthy development of the Korean economy by promoting price stability.”
So, how do fluctuating prices affect the economy and why is it so important? Stabilizing prices is important because it stabilizes the value of the money we spend. When prices rise, we have to pay more to buy the same things. This means that the value of money has decreased. Conversely, if prices go down, you can buy the same thing for less money. This means that the value of money has increased. In order for an economy to grow stably, there needs to be a belief among the members of the community that money maintains a constant value.
Let’s look at this in more detail. Excessive inflation leads to an unequal distribution of wealth and income within a society. Rising prices make it much easier for the already wealthy to increase their wealth. Inflation reduces the amount of goods and services that can be purchased for the same amount of money, which means that most workers living on a fixed salary will actually have less income. Pensioners living on a pension in retirement will also see their income decrease as prices rise. People with savings in the bank will also lose money because their money is worth less. Homeowners who have yet to buy a home will also see their dreams of owning a home become more distant as inflation leads to higher home prices.
While most workers will see their real incomes decrease due to rising prices, the wealthy who already have a lot of property will have a chance to get a piece of the action. In particular, the wealthy who own a lot of real estate, such as buildings, houses, and land, become even wealthier as the value of their real estate increases steeply with inflation. Thus, excessive inflation leads to unequal distribution of wealth and encourages speculation on real assets such as real estate.
Rising prices lead to more consumption and less savings within a country’s economy. This is because money is worth less over time, and it is economically more profitable to spend it now rather than leave it in the bank. As savings decline, it becomes harder for businesses to get financing from banks, which leads to slower economic growth. As inflation continues to rise, the real value of workers’ salaries falls, while real estate prices rise significantly. This creates a sense of deprivation for most people and makes them less motivated to work. That’s a very brief summary of the negative effects of inflation in economics.
But what happens when prices fall? Doesn’t it have any negative effects on the economy? Not really. If prices continue to fall, consumers will delay spending until prices fall further. Why pay more money for a product now when it will cost less over time? Eventually, consumption continues to fall within the national economy. As consumption declines, companies’ revenues and profits decline, and their production activities and investments decline. The result is more businesses going out of business and fewer jobs.
This puts businesses in an increasingly difficult position because they can’t sell the same amount of goods and services for the same amount of money because their prices have fallen due to falling prices. The same principle applies to debt held by a business or household, as the value of money has increased. The value of the physical asset has gone down, but the numerical value of the debt hasn’t, so the value of the debt has actually gone up. For example, if you used to be able to sell your house and pay off your debt, but now the value of your house has fallen due to falling prices, you can’t sell it and still pay off your debt. This puts the borrower under more pressure, and the creditor who lent the money makes a bigger profit than before. In the end, in many ways, it’s better for everyone if prices rise steadily and gradually, rather than in big swings.
