Inflation Defined With the Help of Oranges

Lately, I have been studying a lot about the working and effects of inflation because I wanted to write a short, precise article about it. People are as confused as me, and the government makes it more difficult to understand the term ‘inflation’ by introducing new statistics every week.

Let us understand how and why inflation results in price rise and not vice versa. However, to understand this concept, it’s significant to comprehend relation between:

1. A product and its value
2. Supply and demand
3. Dollars and prices

As soon as you learn these relationships, understanding the impact of inflation on prices will be simpler.

Real Value of a Product or Service

Generally, the value of any product or service is ignored, while calculating the inflation rate considering the price. However, it’s important to understand that there is a difference between it’s cost price and value.

If the world, for instance, didn’t have money, how would you have valued oranges? It’s value would depend on the greatness or deliciousness of its taste, or maybe the nutritional value it facilitates. Quite similarly, the value of a gallon of gas would be measured by the miles you can drive after pouring a gallon in your car’s tank. If the gallon lasts for four days, the value is high. And if it lasts a couple of days, the value is low.

Here, it’s important to notice that the value is nowhere related to money. It’s possible that the value may be higher to someone and lower to somebody else. But, we can definitely value things without money.

Demand and Supply Relationship

It’s quite significant to understand the difference between inflation and price rise due to demand and supply imbalance.

If the crop of orange, for instance, is destructed by heavy frost, the cost price each orange will automatically shoot up. However, this temporary price rise cannot be termed as inflation. Yes, inflation does cause price to hike, but it isn’t the only factor. Prices of any commodity, product, or service can rise due to many factors. One of the most common ones is Demand Supply imbalance.

So, we can correctly say that the current method used by government to gauge inflation is not perfect. If the government reports a raise in Consumer Price Index (CPI), due to the price hike in the cost of oranges that was caused by demand supply imbalance, it isn’t inflation. But they say, higher CPI means inflation, which is a faulty equation.

Amount of Dollars and Its Effect on Prices

Lastly, it’s important to have a look at the relation between cost price of a product and dollars count in the country. All right, to make things simple, let’s us imagine that we are eating oranges in an isolated island with only hundred dollars circulating all around.

The orange is very tasty, and according to our first point, it will have a high value. To gauge the value, we can say that it’s 1/100th of the overall value derived from all the oranges on the island. Okay, I know the figure is unreasonable. But just consider it for a while. The money we have on this island is finite, 100 dollars to be precise.

So 1/100th of the total oranges, which is nothing but 1 orange will cost $1. However, after a couple of weeks, the government of our island brings in a stimulus package of additional $100.

So, now the island has $200, but the value derived from an orange is unchanged. It still provides the same taste and nutritional benefits. It is still 1/100th. But the price per orange increased to $2 from $1 because the government doubled the number of dollars prevailing in the market.

Simple, isn’t it? No, there is nothing else left to explain. Just assume the affect of stimulus package has on the inflation rate. Imagine the outcome of the huge bailout packages the US government is constantly coming up with.