Inflation
Very often people refer to "inflation" in terms of how prices rise over time. From time to time citizens experience changes in the prices of goods and services, where over time prices generally go up. For example, a loaf of bread might have costed €1 last year but now cost €1.10. Inflation refers to the rate of change in prices. In this case, the rate of change, and hence inflation, would be 10%.
People consume a wide variety of goods and services in their daily life, and national statistics office measure on how people's expenditure is allocated across different goods and services. Such "basket" of goods and services typically includes food and beverages, electricity, transportation, clothing and footwear, phone bills, meals in restaurants and takeaways, etc. The relative importance of each item in the basket is measured according to the annual spend on it. Through a survey among households, the National Statistics Office calculates the average of their expenditure patterns to assign the relative importance (or so called "weight") of each good and service in the overall consumption basket for all households. To calculate inflation, the total cost of the basket is compared from one month to another. If the basket cost €100 last year and it takes €103 this year to purchase the same basket of goods and services, then this would mean that prices on average increased by €3. To calculate the inflation rate, we compare the increase to the original price: €3 divided by €100 equals 0.03, which becomes 3% when converted into a percentage. This means inflation is 3%.
The euro area employs a common methodology across all EU countries in collecting prices paid by consumers, also known as the Harmonised Index of Consumer Prices (HICP). The average change in the HICP over time represents the rate of inflation for each country.
What Causes Inflation?
Inflation is usually caused by demand and supply factors.
For example, a strong increase in preference of consumers to purchase a particular product is likely to cause an increase in the price of that product, and hence inflation. Similarly, if a good becomes scarce in supply, its price is likely to go up.
For a small country like Malta, where goods consumed are usually produced in other countries, imported inflation is often an important factor too. For instance, higher prices of imported food and other goods are usually transmitted in higher prices locally. Expectations can also play a role. If people expect inflation to rise in the future, they may spend more today before goods become more expensive, which can itself contribute to higher inflation today as it increases demand today.
Deflation
Deflation is the opposite of inflation, meaning an overall and sustained drop in prices. While this may initially appear beneficial for consumers, over time it harms the economy as it negatively impacts investment, employment, and wages.
When people expect prices to continue falling, they tend to delay spending in the hope of buying later at a lower cost. This reduces demand, which could lead to lower profits, wages, and layoffs, which could in turn lead to even lower prices, and so on.
Hence, in general, while the prospect of lower prices may seem attractive, it can be actually quite harmful.
Central Banks and Price Stability
The primary role of central banks is that of maintaining price stability. This does not mean keeping prices unchanged but keeping the rate of increase in prices (i.e. inflation) stable. A stable rate of increase in prices over time encourages people and businesses to spend and invest rather than hoard money, which in turn helps keep economic activity to grow, supports business development, and creation of jobs. For example, the European Central Bank (ECB) aims to maintain an inflation rate of 2% over the medium term. While deviations in the short term may be tolerated, in the medium term it seeks to achieve price stability through the use of tools known as monetary policy instruments, which are deployed depending on the circumstances at hand.
