When we think about inflation, the first thought that comes to mind is prices going up. But what does it really mean?
Let’s say you’ve got a 2% raise at work. But right after that, prices rose by 5%. This means you did not get a real raise, because after adjusting for inflation, you have actually lost 3% of your purchasing power.
We all know that prices tend to go up over time. The average movie ticket in the France today is 10€. In 1960, when Gone La Dolce Vita was released, it was 28 cents. So in order to compare box office sales between different years, we must adjust to inflation. To do so, economists first pick a list of goods representing what an average consumer buys in a year that we call consumer basket. This allows us to follow the evolution of the basket price throughout the years. You can pick the base year of your choosing in order to determine the consumer price index. The CPI traces how prices have evolved between during the years, and it’s the most commonly used measure of inflation.
It’s worth mentioning that the CPI isn’t perfect because it supposes that the market basket is constant over time, a traditional CPI does not adjust for either new products on increases in product quality. A 1950s black and white TV is nothing like your 40-inch flat screen.
Government economists use adjustment elements to account for technological progress and keep two different years comparable. But in general, we can use the Consumer Price Index to calculate the rate of inflation and how quickly the price levels could rise from one year to another.
In France, prices sped up in the ’40s right after the war, slowed down in the 50’s and 60’s and then sped up again during the ’70s and ’80s, since then it has been slowly rising. On the other hand, prices in Japan have been falling for the past 25 years.
So what causes inflation? What happens exactly?
Let’s say we gave Alan 1 Million euros and asked him to start buying goods. If other people also have the same amount of money, they will be bidding up the prices of goods and services. If Paul offers 15€ for a Pizza, Alan might counter-offer 20€, then Anna would counter-offer back 50. And so it goes on. This is actually called “Demand Pull Inflation”; when there’s a lot of money, chasing much fewer goods.
Another cause of inflation would also be the decrease of availability of a vital productive resource, like oil for example. An oil shortage would increase the prices of gasoline, which itself would increase the cost of processing and delivering flour, cheese, and other ingredients, thus increasing the cost of making Pizza. And therefore a smaller number of Pizzas can be produced. Economists call this Supply Shock, and this causes “Cost Push Inflation”.
So in general, higher demand and lower supply means higher prices.
On the other hand, when it comes to the 2007 Subprime mortgage crisis it’s hard to explain the rise in home prices with only supply and demand. The American population didn’t suddenly skyrocket or get that much richer and there was no shortage of building materials. So what happened? Home prices have diverged from these fundamentals, between the years 2001 and 2006, into what economists call “bubble”. In the early 2000s, low interest rates and fraudulent lending practices encouraged people to buy homes, thus raising demand and increasing prices.
People assumed that this upward trend would continue forever so they liquidated whatever they had and bought houses in the hope of making a profit. The more buyers were pulled into the market the faster prices rose.
The main problem with a bubble is that it depends on an ever increasing supply of buyers, even if each buyer is betting that they will be able to sell at a higher price to the next person. And eventually, you run out of buyers and the bubble bursts.
Bubbles aren’t new. We can all remember the early 2000 stock market crash due to the reckless behavior of investing in anything that ended with a .com or a .net.
Perhaps the mother of all bubbles was the 1630s Dutch tulip mania. Tulips became a status symbol among the upper classes that competed for the rarest bulbs, driving up the prices. At the height of the mania, people traded or sold their possessions, including properties, to participate in the Tulip mania. Eventually the bubble burst and tulip bulbs are now worth less than a euro.