Inflation: there is much talk about it, what does it mean?

Definition. In the last few weeks there has been much talk about inflation, after a long period in which we didn't need to worry about it. But what is inflation? Inflation is a persistent increase in the general level of prices, leading to a fall in the purchasing power of money, that is in the quantity of goods that can be bought for a certain amount of money.

When there is high inflation, we can buy less today than we could yesterday for the same amount of money. How is this possible? Aren't today's 10 euros the same as yesterday's 10 euros? Yes, but if prices have increased since yesterday, we will be able to buy less today for the same 10 euros than we could yesterday.

Who measures inflation? The Italian National Institute of Statistics - Istat - is tasked with measuring the consumer price index for a set number of goods on a monthly basis. The list of items included in this so-called consumer price basket is reviewed and updated every year to reflect changes in household spending behaviours. These behaviours can be affected by exceptional events, such as the COVID-19 pandemic, which impacted purchasing decisions and the structure of consumer spending. In 2021, for instance, FFP2 masks were added to the Istat consumer price index basket.

Why are inflation and deflation detrimental? Inflation poses a threat to price stability. The European Central Bank - along with the national central banks of the euro area, such as the Bank of Italy - pursues the objective of maintaining price stability. The Governing Council of the ECB has defined price stability as a year-on-year increase in the Harmonized Index of Consumer Prices for the euro area of 2% over the medium term. The medium term is a suitable period of time for oscillations - whether positive or negative - due to exceptional events not to be of consequence (for a more detailed explanation click here).

The price variation must be positive, as an inflation rate too close to zero is to be avoided. Indeed, deflation, that is, a decrease in the general price level, has negative effects on the economy. Let us consider some of the negative effects of inflation and deflation.

If prices rise sharply we will tend to make purchases sooner. This behaviour will cause a further increase in the price level, thus triggering an "inflationary spiral" that will reduce the purchasing power of our money. The consequences of hyperinflation are disastrous, as proved by the experience of the Weimar Republic in the 1920s.

Deflation has negative effects as well. If prices go down, we will tend to defer purchases, as we expect prices to keep on decreasing; retailers will no longer manage to sell their goods and they will be forced to lower prices so as to entice us into buying them. Our expectations have proved to be correct! Therefore, we will keep deferring purchases. But if businesses are not selling, they will be forced to reduce their workers' salaries, or to lay them off, with severe consequences for the economy as a whole.

The central banker is in a similar position to the doctor who is measuring a patient's blood pressure. If it is too high, it must be lowered, otherwise the patient faces the risk of disease. However, if it is too low, the patient will not even be able to get out of bed. Both cases - too high and too low blood pressure - must be averted, and so must excessive inflation and deflation rates.