Friday, December 30, 2011

What is inflation?

You know Singapore's inflation surprised experts by being up 5.7% in November 2011. Although housing, transportation and petrol prices contributed significantly, a worrying trend was also the food prices, they were up %3.6.

But what is inflation? What are the causes of inflation? Inflation is actually is a symptom rather than the sickness itself. When the amount of money in an economy increases faster than the amount of goods and services, the overall consumer prices rise. This rise is called inflation. 5.7% rise in November 2011 means, a basket of goods which costed S$100 back in November 2010 now costs S$105.7. This is what the rate of inflation is.

For individual goods, the amount of that good plays a significant role. For example due to the floods in Thailand, the amount of rice supplied to Singapore will probably decrease. But since the money chasing it will not decrease fast enough, the price of rice will probably rise. But foe entire goods and services, the inflation, especially in developed economies, is caused by the faster increase in the amount of the money. I say faster because technology and innovation in developed countries increases the amount of goods and services available. So if the amount of money was fixed, the overall prices would decrease. But since they are increasing, you can conclude that amount of money is increasing.

The below chart shows M2 money supply in Singapore for the last 20 years. M2 is money and close substitutes of money (all time-related deposits, savings deposits, and non-institutional money-market funds) since 1996. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions. M2 is a key economic indicator used to forecast inflation. (Source : Money Supply)

You can see that the M2 increased almost 10% from 2010 to 2011 (actually more since December 2011 numbers are not in yet)! So almost %6 inflation tells us that overall amount of goods and services have not increased as fast from 2010 to 2011.

Singapore M2 Money Supply 1991 - 2011
Still, it is early to say that inflation will be horrifically high like this in the future. Below graph for example shows the inflation rate between 1999 - 2010. The average was %1.5 with a single very high year of 6.5%.

Source :

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