In a market economy, prices of goods and services are created and vary according to supply and demand. If demand for goods that are only available in limited quantity increases, the producers of these goods can raise prices and still find consumers who are willing to pay these higher prices. Periodic increases in the price of one or the other good or service are therefore quite normal.

But if the prices of a large number of goods and services rise continuously over a longer period, we call this phenomenon “inflation”. The term comes from the Latin word “inflare” – to inflate – and reflects the fact that “prices are inflated.”

Inflation can be triggered not only by an increase in demand, but also by the fact that companies begin to pass on rising production costs (due, for example, to wage increases or higher commodity prices) to their customers. This is relatively easy, especially for those companies that have limited competition.

What are the consequences of inflation?

If prices rise, the purchasing power of consumers decreases: with the same amount of money, they can now buy fewer goods and services than before. Inflation is virtually stealing part of your purchasing power, without you even noticing.

If prices continue to rise for a long time, consumers may lose confidence in their money. Instead of saving, they will then prefer “to flee their money” by either exchanging it into foreign currencies or by spending it to acquire material goods – which in turn will again boost demand for goods and thus further accelerate the rise in prices. In the long run, this snowball effect can cause the collapse of the entire monetary system.

The Harmonised Index of Consumer Prices (HICP) measures the evolution of prices

This is why one of the tasks of central banks – and particularly the European Central Bank – is to pursue a monetary policy that ensures some price stability.

To accomplish this task, the Central Bank must be able to measure price developments objectively. Central Banks and statistical offices do this by calculating an index of consumer prices. In the euro area this is the Harmonised Index of Consumer Prices (HICP), which is based on a basket of 700 goods and services for everyday use such as food and clothes, but also cinema tickets or recurring transactions such as housing rents.

The HICP reflects the amount of money households in the euro area have to spend on average for this basket of goods and services.

By comparing these amounts from one year to the next, statisticians can see how prices have evolved and calculate the appropriate inflation rate: the rise in prices, in %, in the course of a year.

However, one can also experience the opposite phenomenon, namely a long period of general decline in prices. This is called deflation.