What is Inflation? Explanation by Our Director for Sustainable Development

I asked Jesse Schwamb, our Director for Sustainable Development, to explain inflation and how it happens. The IMF estimates Zimbabwe's inflation to be over 150,000% and still others say it is even higher. This week, the ZD is trading at $20Million Zimbabwe Dollars to $1USD, a jump from $12M ZD:$1USD on Monday. Craziness!

It's a good read and very informative, without swallowing you into numbers. It helps people like me understand why what is happening is happening and how it impacts our projects. Enjoy!

-Ryan Keith

Memorandum

To: Ryan Keith; President, Forgotten Voices International

CC: All constituents of and volunteers with Forgotten Voices International

From: Jesse Schwamb, Director for Sustainable Development

Date: 2/29/2008

Re: For Immediate Release & Communication: Understanding How Inflation Happens

What is “inflation”?

Inflation may be simply defined as a persistent rise in the costs of goods and services. When things we buy regularly – such as food, fuel, or housing – increase in price, inflation is occurring. A rise in the price of various goods generally means that they are less affordable causing us to react by choosing to buy less, use products more sparingly, or go without. This increase in the overall cost of goods and services over time, and the spending decisions that accompany this change, is what economists call inflation. Inflation, as measure of rising prices, is commonly expressed as a percentage. For instance, you may read in the Wall Street Journal that general inflation in the United State is 3 percent per year. This indicates that prices of basic goods and services (food, fuel, and housing) have increased by 3 percent over the course of 12 months. If a gallon of milk cost $2.50 at the beginning of the year, for example, the same gallon of milk would cost $2.58 at the end of the year with 3 percent inflation. Obviously, those buying milk now have to spend more money to purchase the very same gallon of milk. By way of comparison, the rate of inflation in Zimbabwe has now exceeded 100,000 percent according to estimates made by the World Bank.

How does inflation happen?

There are many complicated economic variables which collectively influence a country’s rate of inflation. However, the following simple example demonstrates the root cause of inflation.

1. In the small fictitious country of Inflationland, there are ten people who want to buy a loaf of bread and only seven loafs of bread available for sale. The bread sellers can increase the price of bread because some people are willing and able pay more to get the bread the want.

2. People – including those making the bread in the bakeries – demand higher wages so they can afford to buy bread. The cost of making bread increases because the bread bakers are requiring more money. So the selling price of bread also increases.

3. When a loaf of bread begins to cost more than people can afford, they stop buying. Fewer loafs of bread are needed, and the bakery lays off workers.

4. Unemployed people buy less of everything so the economy slows down. This is known as a recession. Bread sellers – desperate to sell their small, but stagnant inventory of bread – offer their bread at sale prices.

5. So if ten people want bread and only seven loafs are available, the cycle begins again.

This cycle of inflation is currently occurring within Zimbabwe across a wide array of industries. As demonstrated by the above example, economists generally conclude that inflation is increased (and many times caused) by a scarcity of goods and services. This is particularly true in Zimbabwe where the government has attempted to increase the amount of money available to purchase goods and services without ensuring that there are actually things to buy. When the number of dollars in the hands of consumers exceeds the amount of goods and services available for sale, inflation results and the value of the currency decreases. A combination of high unemployment (over 80 percent in Zimbabwe) and high inflation (100,000 percent) is known as stagflation. Thus, the country of Zimbabwe is currently facing an extremely difficult economic crisis which can be appropriately defined as stagflation.