What is inflation? What are its effects?

The encyclopedic definition of this phenomenon is “a process of increasing the average price level in the economy. This process results in a decrease in the purchasing power of the national currency. So inflation is not something terrible and sudden. However, it is a process that, if left unchecked, can have serious consequences.

What is inflation, and what affects it?

Inflation is an increase in prices and, therefore, a decrease in the purchasing power of money. Put simply: for the same amount at the end of the year, we can buy fewer products than a few months earlier at the beginning of the year because money has less value. And in the case of savings: if someone puts aside USD 1,000 and is not interested in multiplying it, next year they will also have USD 1000, but they will not buy the same amount as before – because prices have increased.

Commodity prices, especially energy prices, are one of the main drivers of inflation. For example, the Energy Regulatory Office approved an increase in tariffs for 2022 for electricity by 24% and gas by 54%. An increase in these prices causes an increase in production costs and, consequently, an increase in prices paid by the consumer. Among other causes of inflation, economists list:

  • increasing the money supply by issuing money by the central bank (in Poland, the National Bank of Poland has the right to issue money), 
  • increase in demand (producers are unable to adjust the structure of production to the structure of consumer demand),
  • unbalanced budget (when the state spends more than it can cover with income),
  • faulty economic structure.

Recent years have been a phase of strong globalization. The incorporation of China or the countries of the former USSR into the global economy meant that we gained a significant amount of cheap labor in global terms, which translated into a drop in prices in global terms. The second important aspect is demographics. In fact, the fact that societies are aging and therefore consume less.

Read also: Limitations of GDP as an Indicator of Welfare

The outbreak of the COVID-19 pandemic has slightly thwarted these global trends. Production processes that were based on continuous supplies from distant Asia were brutally interrupted. Interruptions in production met with increased demand from consumers who switched from services to independent purchases of consumer goods. This confluence of supply/demand factors resulted in a strong increase in prices. An important factor is also inflation expectations, which push employees to their bosses’ offices for wage increases (the so-called second-round effect). Bosses bend under the pressure of employees, but at the same time, they continue to increase the prices of their services or products, and thus the risk of a cost-wage spiral arises.

Effects of inflation

For this section, we will take Poland as an example. They experienced the negative impact of inflation at the turn of the People’s Republic of Poland and the Third Republic of Poland. In 1988, inflation slightly exceeded 60%. This was a very high level, but the real explosion came the next year when inflation exceeded 251%. It was even worse in 1990 when inflation reached 586%. What happened then?

In February 1990, prices of goods and services compared to those in February 1989. increased by over 1100%! The average salary was then PLN 1.03 million, and a loaf cost PLN 2,000. Prices of other commodities rose similarly. A kilo of beef costs over PLN 19,000, and half a liter of vodka – PLN 21,000. 

In order to stop inflation from progressing at such a rapid pace, a reduction in wage growth was introduced by introducing a tax on excessive wage growth. In addition, the government encouraged Poles to accumulate money in banks – a reform was introduced that exempted banks from restrictions on setting interest rates (in such a way that it exceeded inflation).

The actions taken by the economic team of Leszek Balcerowicz (the then Minister of Finance) had an effect already in the following year when the inflation level fell to 70%. This downward march continued, with minor fluctuations, until 2003, when inflation fell below 1%.

What about our savings?

The consequences of high inflation are not favorable. First of all, they cause a decrease in the purchasing power of money, which means that as inflation increases, we can buy fewer goods and services for the same remuneration. We’re getting poorer.

Savings holders are also feeling the rise in inflation. Today, we lose an average of 2 percentage points a year while keeping money on a bank deposit. If inflation continues to rise, then the losses will be even greater.



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