Understanding Inflation: Its Causes, Consequences, and the Policies to Control It

Written by: EDEDDEDDY

Understanding inflation is not merely an academic exercise; it is essential for navigating the modern economic world. Inflation is more than a statistic—it is a powerful economic force that can erode savings, destabilize nations, and ruin lives. It directly affects the purchasing power of our income, shapes investment decisions, and influences the overall stability of the economy. At its heart, inflation is a measure of how quickly the money in our wallets is losing its value.

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1.0 The Fundamentals of Inflation: What It Is and How We Measure It

Inflation is a continuous increase in the general level of prices in the economy. It is crucial to recognize that this does not refer to an increase in the price of a single good, but rather a rise in the overall price level. This means that the purchasing power of money is falling; each dollar buys fewer goods and services than it did before. In essence, inflation is less about the value of goods rising and more about the value of money falling.

To measure inflation, economists and policymakers primarily rely on the Consumer Price Index (CPI). The CPI is a measure of the overall cost of a basket of goods and services bought by a typical consumer. StatsSA constructs the CPI through a international methodology, as follows:

• The "Basket" of Goods: Stats SA identifies a "basket" of goods and services that represent typical household spending (e.g., bread, electricity, fuel, medical care).

  
  

• Updating & Rebasing: In January 2025, Stats SA implemented a major update to the CPI basket based on the 2022/23 Income and Expenditure Survey. The index was rebased to December 2024 = 100.

  
  

• Data Collection: Permanent price collectors visit retail outlets across South Africa monthly. For services like education or rent, they use specialized surveys.

  
  

• Weighting: Not all items are equal. For example, housing and food have much higher "weights" (importance) in the calculation than tobacco or recreation because people spend more of their income on them

  
  

Inflation vs. Price Changes

It is essential to distinguish between a general rise in the price level (inflation) and a change in the price of a specific product. As economist Thomas Sowell clarifies, prices are crucial signals that help allocate scarce resources- I got to S/O Thomas Sowell. When the demand for a particular good, like cheese, goes up, its price rises. This higher price provides an incentive for producers to supply more cheese, drawing resources like milk away from other uses, such as making yogurt or ice cream. This is a relative price change, and it is how a market economy efficiently responds to consumer desires. Inflation, however, distorts these signals. A general rise in all prices, driven by an increase in the money supply, doesn't reflect a change in consumer wants or the scarcity of particular resources. Instead, it creates confusion and can lead to the misallocation of resources, as producers may misinterpret the general price rise as an increase in genuine demand for their specific products.

The mechanism that enables a general rise in all prices is found in the nature of modern money itself, and how its value is determined.

2.0 The Nature of Money and Its Link to Prices

Understanding how money is created and valued is strategically important for grasping the mechanics of inflation. The historical shift from currencies backed by tangible commodities to currencies based on government decree is central to the modern inflation debate.

From Gold to Government Decree

Historically, money often took the form of commodity money, which used a commodity with intrinsic value, such as gold. Gold is inherently limited in supply, a characteristic that served to deprive governments of the power to simply create more money and cause inflation.

Modern economies, however, use fiat money, which is established as money by government decree. Fiat money has no intrinsic value; it is simply pieces of paper or entries in a digital ledger. This raises a common and important question: what backs modern currency? The answer is that fiat money is not backed by a physical commodity like gold but by the trust and confidence people have in the government that issues it. This trust is not arbitrary; it is rooted in the stability of the government, its power to levy taxes to meet its obligations, and the productive capacity of the economy it governs.

The Quantity Theory of Money: Why Printing Money Leads to Higher Prices

The fundamental relationship between the quantity of money and the overall price level is one of the oldest and most established theories in economics. The explanation for inflation is straightforward: prices rise when the government prints too much money. As N. Gregory Mankiw states in Principles of Macroeconomics:

In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money.

This principle can be illustrated with a simple narrative. Imagine an economy that produces 1,000 goods and services a year, and the total amount of money in circulation is R10,000. The average price of each item would be R10. If the central bank suddenly doubles the amount of money to R20,000 but the volume of goods and services remains the same, prices will inevitably rise. With twice as much money chasing the same amount of goods, the average price will double to R20. This illustrates a core insight from Thomas Sowell: a government cannot make its citizens prosperous simply by printing more money. It is the volume of goods and services that determines whether a country is prosperous, not the amount of paper money in circulation.

This direct link between the money supply and the price level means that the government institution in charge of that supply—the South African Reserve Bank—stands at the forefront of the battle against inflation.

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3.0 The Central Bank's Toolkit: Policies to Combat Inflation

SARB, is the primary institution responsible for maintaining price stability. It achieves this by using a set of powerful tools to influence the money supply and the cost of credit, thereby managing aggregate demand in the economy. When facing inflationary pressures, SARB can implement policies to cool the economy and bring price increases under control.

Here is exactly what those "tools" are and how they actually work:

1. The Repo Rate (The "Volume Knob")

This is the most famous tool. The Repo Rate is the interest rate the SARB charges commercial banks (like Absa, FNB, or Capitec) to borrow money from it.

• How they use it: If the SARB thinks inflation is too high, they "turn up" the knob (increase the rate).

• What happens next: It becomes more expensive for your bank to get money. To keep their profits, the bank raises the Prime Lending Rate. Suddenly, your car and house repayments go up.

• The Result: You have less "extra" money to spend on clothes or eating out. When millions of people spend less, businesses stop raising prices as quickly, which brings inflation down toward the 3% target.

  
  

2. Open Market Operations (The "Vacuum Cleaner")

Sometimes there is too much "extra" cash floating around in the banking system. If banks have too much cash, they might lend it out too easily, which can cause inflation.

• How they use it: The SARB sells Debentures (basically "IOUs" from the Reserve Bank) or government bonds to the commercial banks.

• What happens next: The commercial banks give their cash to the SARB in exchange for these papers.

• The Result: It’s like a vacuum cleaner—the SARB sucks the "excess" money out of the system so it can't be used to over-stimulate the economy.

  
  

3. The Transmission Mechanism (The "Pipeline")

Using a tool is one thing, but it has to travel through the "pipeline" to reach your pocket. This is called the Monetary Policy Transmission Mechanism.

When the SARB uses a tool (like changing the repo rate), it flows through four main channels:

1. Interest Rates: Changes how much you pay on debt.

2. Asset Prices: Affects the value of the stock market and houses.

3. Exchange Rate: A higher interest rate often makes the Rand stronger, which makes imported goods (like petrol and electronics) cheaper.

4. Expectations: If the SARB says they are "fighting inflation," businesses might decide not to hike their prices next month because they trust the Bank will keep things stable.

   
   

4. Communication (The "Loudspeaker")

In 2026, the SARB's voice is as much a tool as the interest rate itself. By clearly stating, "We are aiming for exactly 3% inflation," they guide the "expectations" of the market.

If everyone believes inflation will be 3%, they tend to set their price increases and salary demands at 3%. This makes the SARB's job much easier because the economy begins to regulate itself without the Bank needing to hike interest rates aggressively

In essence, these central bank tools are attempts by a central planning agency to manipulate the price of credit to approximate the outcome a free market for money might achieve. This highlights the immense knowledge problem and risk involved, as a miscalculation can lead to either runaway inflation or an unnecessary recession. These tools work by making borrowing more expensive across the entire economy. Higher interest rates reduce household and business spending on goods and services—or aggregate demand. This reduction in demand alleviates the upward pressure on prices, thereby curbing inflation.

The effective use of these policy tools requires careful judgment, as their consequences ripple throughout the economy, translating abstract policy decisions into tangible outcomes in the daily lives of every citizen.

4.0 The Human Cost of Inflation: What It Means for the Everyday Person

Beyond the abstract statistics and policy debates, inflation has profound and tangible consequences for individuals, families, and the social fabric. It is a disruptive force that can undermine personal financial security, distort economic behavior, and breed social discontent. Understanding the human cost of inflation reveals why controlling it remains a central goal of economic policy.

Erosion of Savings and Fixed Incomes

Inflation systematically diminishes the purchasing power of money. For individuals who have diligently saved for the future or who live on fixed incomes, such as retirees, this can be devastating. The money they set aside buys less and less as prices rise. This sentiment was captured vividly by Ernest Hemingway:

Inflation is the time when those who have saved for a rainy day get soaked.

Arbitrary Redistribution of Wealth

Unexpected inflation arbitrarily redistributes wealth in ways that have nothing to do with merit or need. It primarily benefits debtors at the expense of creditors. For example, a homeowner with a 30-year fixed-rate mortgage gets a significant advantage during a period of high inflation. They get to repay their loan with dollars that are worth far less than the dollars they originally borrowed, effectively reducing the real value of their debt. The bank or lender, on the other hand, receives repayment that has less purchasing power.

Distortion of Economic Decisions

Inflation acts as a subtle but pervasive tax. As economist N. Gregory Mankiw notes, it is a "tax on everyone who holds money" because it erodes the real value of cash. This leads to several inefficiencies and costs:

• Shoeleather Costs: This refers to the resources wasted when people try to avoid holding money. In an era of high inflation, this can mean wasting time and resources constantly moving money between different types of accounts to protect its value, instead of focusing on productive work.

• Menu Costs: For businesses, inflation creates "menu costs"—the costs associated with changing their listed prices. This can include printing new menus, updating catalogs, or changing price tags, all of which consume resources that could have been used more productively.

Increased Uncertainty and Social Conflict

Rising prices make people unhappy and can erode social cohesion. As different groups in society see their cost of living increase, they often start blaming one another—workers blame firms, firms blame workers, and everyone blames the government. In its most extreme form, hyperinflation can cause the complete collapse of a society. In Zimbabwe in the late 2000s, the government printed so much money that the inflation rate reached an estimated 5,000,000,000,000,000,000,000 percent. At that point, the currency was worthless, the economy was in ruins, and the social fabric had completely unraveled.

These diverse and damaging effects are why governments and central banks around the world make controlling inflation a primary policy objective.

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5.0 Conclusion: The Enduring Challenge of Price Stability

Inflation, at its core, is a monetary phenomenon driven by an excess supply of money relative to the goods and services available in an economy. When a government or its central bank creates too much money, the value of that money falls, and prices rise. While the policy tools to control inflation are well-understood, their application requires careful judgment and always involves trade-offs.

This highlights the perpetual tension between the desire for short-term economic stimulus and the long-term necessity of sound money. The temptation to print money to finance spending or to stimulate growth is an enduring feature of political life. Yet, as history has repeatedly shown, yielding to that temptation leads down a path of economic instability and social strife. Maintaining price stability is therefore one of the most important, and most challenging, functions of economic policy. A public understanding of these principles is vital for responsible citizenship, as it empowers individuals to evaluate public policy and hold their leaders accountable for preserving the value of their currency and the prosperity it enables.

Disclaimer: The views and analyses expressed on this blog are for informational and educational purposes only. This site serves as a self-guiding diary intended to facilitate my personal understanding of specific subjects and does not serve as an authoritative reference. Information is provided "as is" without any guarantees of completeness or accuracy. Please consult a local, professionally trained economist for any formal inquiries or professional advice

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Reference:

Mostly based on the Textbook: " Basic Economics, 4TH ED by THOMAS SOWELL