What Is Inflation?

Inflation is a word that is heard in the morning news in the economic newspapers and in the news sections. Because most of the time it has negative connotations, people are put off when the word inflation is thrown into the air.

But what exactly is inflation? Inflation is a situation where the prices of many products go up at the same time. If the price of one product rises relative to other products, it is not evidence of inflation. For example, in Israel from 2007 to 2020 there is a steady increase in real estate prices. However, inflation in these years is considered very low, because the prices of other non-real estate products not only did not rise but sometimes fell. An example of these products is clothes bought on sites from abroad.

So what then is inflation?
The prices of the products we purchase change over time. In the early 1990s, it was possible to buy a glacier for 10 agorot, then for 25 agorot, and then for half a shekel. From January 2008 to June 2011, the price of beloved cottage cheese rose by 40%. This rise in cheese prices was one of the factors that took Israeli consumers to the streets, to the social protest of 2011.

A state of rising product prices is a well-known phenomenon in most countries of the world, however, the prices of the various products do not rise at the same rate for a given period of time. The reasons for the rise in prices are many and varied. At the same time, when the prices of most products rise over time, the consumer’s ability to buy decreases if his income does not increase by the same rate. This situation is undesirable and therefore the central bank of the country, which is responsible for price stability, intervenes when there is constant or extreme high inflation.

How do you measure the change in product prices over time?

The accepted index for measuring the rate of increase in prices is the consumer price index. The consumer price index measures the cost of an average basket of products that a family consumes per month. Every year, the Central Bureau of Statistics conducts a survey of household expenditure. According to these surveys, it builds an average monthly product basket for the average family in Israel, which it publishes in a press release. This basket has a fixed amount of vegetables, fruits, other types of food, housing, expenses for transportation, education, clothing, etc. The cost of the basket changes every month with changes in prices, but assuming the quantities consumed on average do not change, the change in basket cost reflects The change in prices in the economy, at this link you can read the announcement that was released to the media in July 2019.

A numerical example of calculating the consumer price index and calculating inflation

Suppose that in January 2019 the price of the basket is 10,000 NIS. If we define January 2019 as the base month, then we can say that when the basket rises NIS 10,000, the index is 100.00. Suppose that in February 2019 the price of the basket will be NIS 10,500. This means that the basket has risen by 5% relative to the previous month. The consumer price index in this case will be 105.

The change in the price index is inflation, and it is measured as a percentage. That is, the rate of increase in the price of the consumption basket in the country is expressed as a percentage change. In the case I described, the consumer price index rose by 5% because the price of the basket rose by 5% and therefore inflation was 5%.

Why is inflation such an important concept in the economy?

Prices are a key component in our ability to consume the products we need or are interested in for our well-being. If prices go up and our income does not change, we can buy fewer products than we are used to. It is a situation where our economic situation is changing for the worse. The Bank of Israel is the institution responsible for price stability in Israel. It is important to understand that we strive for price stability, not general price reduction, because general price reduction can lower incentives to produce. If a manufacturer sees that the price that the product he is producing has decreased, then his income will decrease, and the incentive to produce the product has decreased. The Bank of Israel has set an inflation target of 2% per year. At a rate of price increase of 2% per year, on the one hand, our purchasing power is not dramatically impaired, and on the other hand, the incentive to produce is not dramatically impaired.

There are all kinds of economic tools with which the Bank of Israel can influence the rate of inflation, which is the rate at which prices increase in the economy. Its main tool is changing the interest rate. I will discuss how the Bank of Israel operates in a separate post.

Inflation, loans, and savings

Beyond the effect of inflation on our purchasing power, loans and savings can, under certain conditions, be linked to a change in inflation. This means that changes in inflation can affect loan repayments as well as the accumulation of savings.

Example 1: Suppose I deposited NIS 10,000 in a savings plan at an interest rate of 5% per year. Assume that the savings plan was not linked to inflation, meaning I will not receive any compensation if prices rise. If inflation also rose by 5% per year, then in fact at the end of the year I will receive NIS 10,500. But the prices of the products I consume have also risen by the same rate, so even though I gave up the use of money, the rise in interest rates was fully offset by the rise in prices. In this situation, I may have maintained the purchasing power of the money by having the interest rate compensated me for the rise in inflation, but I received no compensation for refraining from using the money for an entire year.

The situation could be worse if the prices went up more than the interest rate offered to me for the savings. This is the situation in Israel today – the interest rate on deposits per year is usually about 0.05% (which is close to zero), while inflation can be 2%. This means that at the end of the year when I get my money I will consume less than I could have consumed with the same amount at the beginning of the year!

Example 2: Suppose I took out a loan whose repayments are fixed (Spitzer) and it is not linked to inflation. If prices go up, it means that the value I return to the bank actually goes down. That is, if the monthly repayment is NIS 1,000, then at the beginning of the year, when I returned NIS 1,000 to the bank, I gave up purchasing products worth NIS 1,000 for the savings period. At the end of the year, if prices rose by 2%, then the economic significance of the NIS 1,000 I returned to the bank in the last month of the year is actually a waiver of products worth NIS 980.

Example 3: Suppose I took out a loan with a monthly repayment of NIS 1,000 whose repayments are linked to inflation. If inflation rose by 2% at the end of the year, then the return will rise to NIS 1,020. Of course, if we take out a long-term loan where inflation can rise significantly, it can dramatically affect our loan repayments in the future.