Why is an inflation rate of 4 percent considered desirable?

The rate of inflation and the development of monetary value

Calculation methods for inflation

There are various methods for determining inflation, i.e. the sustained increase in goods prices, in which different factors are taken into account. A very simple way to calculate inflation is the following formula: Inflation rate = (current price - previous price) ÷ (previous price) × 100

The calculated inflation rate indicates how the price has changed in the period under review. Since prices usually increase, the price increase also results in the loss of purchasing power of money, since one now has to pay more for the product or receives less from the product for the same amount of money. The following two examples show that inflation has a serious impact on purchasing power: Assuming an annual inflation rate of 2.5 percent, you would have to pay 209.76 in 30 years for a product that costs 100 euros today . From today's perspective, a pension of 1,000 euros would only have purchasing power of 476.74 euros at the same inflation rate in 30 years.

Imaginary shopping cart

In Germany, the inflation rate is officially calculated using an imaginary shopping basket. This shopping basket for calculating inflation is a statistical variable and contains a representative selection of different products that are regularly in demand. These reflect the average consumption. The determination of the inflation rate in Germany is carried out by the Federal Statistical Office Destatis - per month and for the entire year.

When calculating the price level with the help of an imaginary shopping cart, however, various problems can arise. Improvements in the quality of goods are not always precisely recorded. The Federal Statistical Office has tried to counteract this since 2002 with the so-called "hedonic price adjustment", which is, however, not entirely undisputed, since deterioration in quality is not taken into account here. Another problem is the increasing time lag between the base year and the calculation year, as consumer behavior changes over longer periods of time. Furthermore, important economic areas, such as the financial goods and real estate sectors, are not covered by the shopping cart.

Causes and Consequences of Inflation

Inflation is a currency devaluation that comes from outside. Rising import prices are also causing prices to rise domestically. Monetary inflation theories explain high inflation rates with an increase in the amount of money and an accelerated rate of circulation of money. If at the same time production stagnates or falls, inflation occurs. In essence, demand and supply in an economy are important to inflation. Therefore, the causes of a price increase can come from both sides:

Demand inflationSupply inflation
  • Increasing demand means higher prices.
  • This can be triggered, for example, by a higher wage level.
  • Higher personnel or raw material costs, but also higher profit margins, drive prices up.
  • Imported inflation in particular can play a role here.

When asked about the consequences of inflation, it always depends on the strength of the inflation. Low inflation is normal, but when the rate of inflation is high, price increases can have a very strong impact, especially in the long term. Similar to the compound interest effect, the prices do not increase linearly, but progressively. The following table illustrates this effect. This is based on an article that currently costs 100 euros. In the table you can see how high the price will be in five, ten or fifteen years for the same item, assuming different inflation rates.

Price of an item that costs 100 euros today

inflation rate1 %2 %5 %10 %15 %
After 5 years:105.10 euros110.41 euros127.63 euros161.05 euros201.14 euros
After 10 years:110.46 euros121.90 euros162.69 euros259.37 euros404.56 euros
After 15 years:116.10 euros134.95 euros207.89 euros417.72 euros813.71 euros

The inflation rate not only has an impact on the purchasing power of money, but also on political decisions, for example setting the standard rates for unemployment benefit II. In addition, the inflation rate plays an important role in collective bargaining.

Different rates and phases of inflation

Inflation can take on different dimensions. While creeping inflation is considered normal, galloping inflation already harbors the risk of hyperinflation, which brings severe economic damage and is a danger for the currency itself - like the inflation of 1923 in Germany. When looking at inflation, it is divided into either speeds or phases. When it comes to speed, a distinction is made between:

Creeping inflationUp to 3 percent per year, hardly any noticeable price increases
Trotting inflationUp to 10 percent per year, clearly noticeable price increases, declining willingness to invest in the economy
Galloping inflationOver 10 percent per year, very rapid rise in prices, risk of hyperinflation
HyperinflationOver 50 percent per month, currency devaluation that is no longer controllable, the currency itself is at risk

However, since this classification is largely arbitrary, there is more and more of a trend towards dividing inflation into an accelerated (increasing), a stabilized and a decelerated (weakening) phase. The perceived inflation is not a real currency depreciation. Rather, it reflects the subjective feeling about an increase in prices in the population - without this feeling having to have a real basis.

After the introduction of the euro as a means of payment in cash transactions, there was often talk of inflation triggered by the currency changeover in Germany and Europe. The euro was considered to be “expensive”. Statistically, however, inflation due to the euro as the new currency could not be determined in Germany. There was also no noticeable increase in inflation in the eurozone. Hidden inflation, on the other hand, is currency devaluation that is not perceived, but actually exists - it is therefore the counterpart to perceived inflation.

Is Hyperinflation Still Possible Today?

In mid-November 1923 a bread cost 80 billion marks in Germany. The hyperinflation of 1923 in Germany had its causes in the lost war, high reparation payments to the victorious powers and above all in the decision of the government to settle the immense national debts by a massive increase in the money supply (i.e. by cranking the money press).

A comparable situation does not exist today and is hardly conceivable any more. Above all, increasing money supply alone is not a sufficient trigger for hyperinflation. Because although the amount of money in the euro area has doubled in the last four years, there is a decisive difference to 1923: only a small part of the money from the European Central Bank reaches private consumers or companies. The largest part moves in a cycle between the banks and the central bank.

In addition, since the outbreak of the financial crisis in 2008, the financial institutions have been very reluctant to grant loans - and that is in fact the production of additional money.

Current inflation rates in Germany

The inflation rate in Germany was just under one percent in 2014 - that practically means price level stability. In February 2015 the value was only 0.1 percent, in the previous month it was even negative: minus 0.4 percent. The development of the inflation rate in Germany has been declining for several years:

  • 2011: 2,3 %
  • 2012: 2,0 %
  • 2013: 1,5 %
  • 2014: 0,9 %

Experts expect an inflation rate of 0.5 percent for 2015 - if the trend does not reverse. Measured against the general goal of a moderate inflation rate of between two and three percent, there is more of a risk of deflation than inflation. This could have serious consequences for the economy as consumers postpone purchases in anticipation of further falling prices. That in turn would have an extremely negative effect on domestic demand and thus on the economy. With its low interest rate policy, the ECB is trying to counteract the threat of deflation in the euro area. As the ECB has not yet fully exhausted its possibilities, deflation is not expected for the time being - the risk of deflation still exists, however.

How Much Inflation is Good for the Economy?

One hears again and again that a certain inflation is definitely desirable. The reason for this is quite simple: moderate inflation has a stimulating effect on consumers' buying mood. When there is a general awareness that prices will rise in the long term, the money will happily be spent on consumer goods.

Low but noticeable inflation makes investments less attractive, because interest rates - especially for short-term investments - are often barely above the rate of inflation and sometimes even below it. Too high inflation, on the other hand, can permanently undermine people's confidence in their own currency.

On the other hand, inflation is ideal to compensate for debts, because as prices rise - at least in nominal terms - so do the profits of companies, making it easier to repay existing liabilities.

Measures against inflation

In order to counteract excessive inflation, state price fixing is of course initially conceivable. In the past, however, these measures have regularly proven to be hardly effective. For example, in the early 1970s the Nixon government in the USA was unable to stop inflation by fixing the prices of salaries and goods. Interest rate hikes, on the other hand, have proven to be an effective means of combating excessively high inflation - in the eurozone the ECB would be responsible for this as the “guardian of the currency”. Interest rate hikes can be effective in curbing the creation of money (for example, by lending to consumers). A loan comparison increases the chances of finding the right loan enormously.

This reduces the money supply overall. According to the principle of supply and demand, the value of money itself increases. In times of high interest rates, consumers would rather put their money in banks than spend it. As with many other economic and financial developments, inflation has winners and losers:

  • Inflation winners:
    • Debtors (pay back their debts with "worthless" money)
    • State (more state revenue, devaluation of national debt)
  • Inflation loser:
    • Fixed income earners, e.g. employees (wages that remain the same despite price increases)
    • Saver (loss of value of money)

International comparison of inflation

A 1-to-1 comparison of international inflation rates is not always possible. This is partly due to different calculation methods, and the shopping carts in different countries differ. Inflation in the US was around 2 percent in 2012 (similar to Germany), while inflation in Russia was more than twice as high: 5 percent.

Recently, the EU's import bans have been troubling the Russian economy. Purchasing power is also suffering as a result: inflation of 15 percent was measured in March. Another country with very high price increases is India, for example. Here, consumer prices in 2012 were a good 10 percent higher than in the previous year. The global inflation rate in 2013 was around 3.7 percent.

The following is an overview of the inflation rates of some industrialized and emerging countries for 2012:

  • India: 10.3%
  • Brazil: 5.2%
  • Russia: 5.1%
  • China: 3.0%
  • Germany: 2.2%
  • USA: 2.0%
  • France: 1.9%
  • Japan: 0.04%

Private strategies against inflation

How can you best protect yourself against inflation? Real estate, stocks and gold are still considered safe havens for money at risk of inflation. Experts recommend a gold investment as crisis insurance, which should account for up to 10 percent of private assets. Real estate can also prove to be of stable value in the long term - if the current income increases as quickly as the costs. In contrast, stocks only offset the loss of purchasing power of money well in times of moderate inflation. In the case of galloping inflation or hyperinflation, securities are also dragged into the whirlpool of monetary devaluation.