What is inflation?
Inflation happens when the cost of goods and services increases. If you notice a hamburger that cost $2 a year ago is now $5, that's inflation.
In simple words, inflation weakens a consumer's average purchasing power. In the hamburger example, you need three extra dollars to buy the same product. During inflation, you'll discover your dollars can't get you as many things as they used to.
There are various types of inflation, but the primary cause is always the same: There's too much money in circulation. When the supply of money in a country increases, each dollar bill becomes diluted. Other causes of inflation can include an increase in wages, low interest rates, and supply chain disruptions. Economists often measure this purchasing power as a percentage change to gauge the inflation rate.
Fiat currencies like the U.S. dollar or the euro aren't backed by scarce assets like gold. Instead, these currencies are notes issued by the government and a central bank like the U.S. Federal Reserve. Since there's nothing but trust in the government backing fiat currencies, they’re relatively easy for central banks to inflate.
Whenever central bankers believe the economy needs inflation to spur demand, they can print money and distribute it among citizens. For instance, the Fed created $3 trillion and distributed it to help Americans during the 2020 COVID-19 shutdown. According to the Federal Reserve Economic Data (FRED), over 80% of all USD in circulation was created between 2020 and 2021. Globally, Bank of America analysts estimate nations spent about $20 trillion on stimulus measures to deal with the COVID-19 health mandates.
This massive money printing was a key contributor to inflationary pressures in the post-2020 world.
Calculating inflation
The most common way agencies report on inflation is by tracking the average price of a "basket of goods." This basket could include various products and services either from the consumer or producer side. For example, the Consumer Price Index (CPI) from the U.S. Bureau of Labor Statistics focuses on average consumer needs such as energy and food. The Wholesale Price Index (WPI) and Producer Price Index (PPI) concentrate on the prices of raw materials and retail items before they become available to the public market.
While every agency has unique "baskets" and methodologies, here's a general overview of how they calculate inflation:
- Determine a basket of goods: First, an agency will choose a set of consumer or producer goods to include in its basket of goods. These could consist of the cost of raw materials, real estate, healthcare, or oil prices. Analysts will also assign a specific percentage to each item in their basket to determine their final number.
- Monitor the basket of goods' prices: Once economists choose the goods and services to analyze, they’ll track the average prices over a set timeframe and update many inflation metrics, like the CPI, monthly.
- Choose a prior data period: Analysts will gather data from previous months or years to understand how today's prices compare with previous times. Indices like the CPI and WPI have decades of data that economists can use to gauge long- and short-term inflation rates.
- Subtract and divide the current basket of goods by prior data: After collecting all their target numbers, economists use the following formula to calculate the inflation rate:
[(Current Price-Previous Price)/Previous Price] x 100 = Inflation rate
As a simple example, let's say you were interested in calculating the one-year inflation rate of your favorite pizza. If a small pizza costs $4.50 in 2021 and $5 in 2022, you'd set up your formula as follows:
[($5 - $4.50)/$4.50] x 100 = 11.11
This means the annual inflation rate for your pizza between 2021 and 2022 was 11.11%.
The effects of inflation
While inflation may sound alarming, there are some cases where it can be positive for an economy. If businesses naturally raise their prices, it suggests there's strong consumer demand. Increased spending is a sign of robust economic activity, which should help overall commerce, trade, and employment.
However, there's a fine line between "healthy inflation" and unsustainable "hyperinflation." When a currency "hyper-inflates," it becomes practically worthless. When dollars become valueless, countries are prone to civil unrest as people can't afford necessities.
Venezuela's Bolívar currency is one of the most noteworthy inflation examples in recent years. Estimates suggest Venezuela's fiat currency had an inflation rate of approximately 100,000% in 2018. The Bolívar has become so worthless that many Venezuelans fled the country, and most transactions in Venezuela happen using USD.
When a currency inflates to the levels of the Venezuelan Bolívar, people won't be as prone to buy products and services, thus curbing economic activity. Businesses tend to downsize during inflationary periods, leading to an uptick in unemployment. It's also less likely outside investors will help an economy with high inflation. If money will be less valuable in the future versus today, people will spend as soon as they receive it, leading to a decrease in savings.
If there's not enough demand to meet the increased supply of a currency, a country will have to contend with the consequences of inflation.
Controlling inflation
Most countries have central banks tasked with monitoring the inflation rate. Besides analyzing average inflation rates, institutions like the Fed can use a few tools to influence inflationary pressures.
- Increasing interest rates: Central banks often try to decrease inflation by curbing consumer demand. To do this, institutions increase the average interest rates to borrow money. While reducing demand can help bring prices down, it can slow economic activity and growth. Higher interest rates can trigger a recession or depression.
- Increasing bank reserves: Another way central banks combat inflation is by raising the minimum amount commercial banks need in their reserves. These heightened requirements keep banks from lending as much money, thus decreasing the supply of cash in the economy. Just like increasing interest rates, this strategy usually slows economic activity, which runs the risk of triggering a recession.
- Increasing bond interest rates: Governments may also attempt to combat inflation by making the yields on their bonds more attractive. More investors will likely purchase government bonds with a higher guaranteed interest rate. Not only does this take more cash out of a country’s circulating supply, but it also helps the central government attract more funds.
It’s important to note that it’s immensely difficult to control inflation, and many of these strategies are blunt force tools that have several collateral effects.
Inflation today
Although inflation had been a concern before the COVID-19 pandemic, it has become an unavoidable issue post-2020. Nations printed billions, if not trillions, to help citizens during stay-at-home health orders. Today, virtually every country is facing inflationary pressures due to these decisions.
For example, the U.K. posted its highest inflation rate in 40 years, with a 10.1% increase in its CPI for September 2022. Similarly, the Netherlands published a record inflation rate of 14.5% in the same month. In March 2022, the U.S. posted a CPI score of 8.5%, the highest inflation rate since the 1980s.
The United Nations notes that rising inflation is particularly hurting countries in the developing world. For instance, the UN pointed out that many developing countries in Latin America, the Caribbean, and Western Asia have annual inflation rates in the range of 14-17% in 2022. The UN also argues that increased interest rates in developed nations like the U.S. could reduce yearly income in the developing world by as much as $3.6 trillion.
Inflation and crypto: What's the connection?
Inflation has always been a central concern in the cryptocurrency industry. Indeed, one of the hallmarks of Bitcoin's design is its decreasing inflation rate. Bitcoin's mysterious creator Satoshi Nakamoto envisioned a digital currency that would exist outside the control of central banks, governments, and businesses. There are no policymakers that can tinker with Bitcoin's monetary policy.
Although cryptocurrency is still considered a speculative technology, many crypto supporters believe projects like Bitcoin and Ethereum can provide a solution to runaway inflation. A few features in cryptocurrency's favor include:
- Reliable issuance schedule: One of the hallmarks of Bitcoin's design is its reliable "halving" schedule. Since its launch, Bitcoin's inflation rate has been cut in half every four years, and that’ll continue to happen until it reaches its hard-cap supply of 21 million BTC. This predictable inflation schedule stands in contrast to ever-changing policy decisions from central banks.
- A few cryptos are deflationary: Some crypto projects build deflation into their token issuance. Most notably, Ethereum burns a "base fee" whenever people transact on the blockchain. As more people use the Ethereum blockchain, this burn rate could exceed Ethereum's daily issuance, thus making ETH a deflationary asset. Binance's BNB Coin is another prominent cryptocurrency with a similar burning mechanism.
Although these features make crypto an attractive "inflation hedge," some seasoned crypto enthusiasts have concerns about this new form of digital currency. A few reasons crypto has yet to become an inflation antidote include:
- Price volatility: Although the crypto market cap has been steadily increasing over the past decade, it's far more volatile than other asset classes. Conservative investors are still uncomfortable with the wild price changes in digital currencies like Bitcoin and Ethereum.
- Difficult to access in many regions: Currently, crypto is most easily accessible in tech-savvy developed countries. Developers and crypto supporters need to increase awareness, education, and access to citizens in developing countries.
- Prone to hacks and scams: Due to the lack of regulation in the crypto space, many crypto scams have happened in recent years, and many hackers have successfully broken into crypto projects and exchanges. These security concerns and lack of insurance protections make many average investors fearful of crypto.
Wrapping up
At Worldcoin, we believe cryptocurrencies can provide a solution to inflationary pressures. However, if crypto is going to achieve its goals, it needs to find its way into the lives of more citizens. That's why we aim to put a share of our crypto in the hands of every individual on the planet for free. Not only that, but we’re also airdropping free DAI tokens to anyone who downloads our app. Subscribe to our blog to learn more.
