Background on the subject

The effects of the war are spreading faster than anyone thought. The world economy is being hit hard and this is happening shortly after the Covid-19 pandemic.

My current knowledge on this subject is limited to understanding the impact of the current conflict on the price of gas and oil. Switzerland imports a lot of petroleum products and this has an effect on the price of petrol as it does in many countries in Europe. What I find even more alarming is what is happening to agriculture. I heard on a Swiss political programme that famine projections could affect more than 40 million people especially in Africa where they import 100% of their wheat from Ukraine or even Russia. In this article, I want to understand what inflation is and its impacts but also understand what could happen to our economy in the coming months.

What is inflation? How can it directly impact on the cost of living? To answer these questions, I will use articles, documentaries and interviews on the subject.

What is inflation?

 The term inflation refers to an increase in prices of goods and services. Inflation is also the increase in the circulation of money (money supply).

The rate of inflation is measured by the consumer price index (CPI), a measure of inflation that covers a wider area than household consumption. The objective of the monetary policies pursued by the major central banks is to maintain a steady rise in the general price level. The European Central Bank (ECB) aims to bring the inflation rate in the euro area down to 2%. A moderate level of inflation affects businesses by encouraging investment decisions, but also households by encouraging them to invest their cash rather than keeping it in their bank accounts. There are four main drivers of inflation:

Cost-push inflation

The price of a product can rise when the cost of manufacturing it increases or because the prices of the products that make up the product rise. The increase in the manufacturing price is usually due to an increase in wages. Increases in the cost of raw materials put pressure on the production costs of companies. When these raw materials are purchased from abroad, this is called imported inflation. Cost inflation can lead to an inflationary spiral. In order to maintain their profit margins, companies have an incentive to raise their prices. This increase in prices has a direct impact on wage levels, which in turn increase.

Demand-side inflation

This type of inflation occurs when the demand for products or services increases but supply fails to keep up with the increase in demand. Firms undertake investment programmes to increase production and expand their workforce, which helps to stimulate economic activity and aggregate household demand. However, as long as the quantities created fail to keep pace with aggregate demand, prices continue to rise.

Imported inflation

The fall of a currency against the dollar or other major world trade currencies such as the yen, the euro or the pound sterling, leads to an increase in the price of imported products. This inflation is repeated across all sectors of the economy and affects businesses and households. This phenomenon can be linked to a significant increase in the price of energy and agricultural products on world markets.

Inflation due to excess money supply

Some economists consider that inflation occurs when the stock of money circulating in the economy is too high in relation to the quantity of goods and services offered. In this case, an excess of money supply created by commercial banks or by the financing of the public deficit by the central bank is at the origin of inflation. Inflation is therefore fuelled by excess demand and the fall in the exchange rate.

Moderate inflation has positive effects on the economy. Inflation that is too high can have negative effects on the economy. It leads to a decrease in the price competitiveness of domestically produced products compared to those produced abroad. This creates a drop in activity for domestic companies, which can lead to downsizing and thus higher unemployment. High inflation creates uncertainty about future price levels. Companies are then cautious about investing, as profitability is difficult to anticipate. Excessive inflation also penalises households, which suffer a loss of purchasing power. They reduce their consumption to maintain their current standard of living. One of the objectives of the European Central Bank (ECB) is to guarantee price stability. To achieve this, it targets a 2% inflation rate, which represents a moderate increase in prices. It also seeks to avoid the risks of deflation which are at the root of the contraction in economic activity. (RTS)

Moderate inflation has a direct impact on :

Businesses: they will be able to set their expectations for price increases in the medium and long term. Predictable inflation helps investment decisions as it reduces uncertainty about future profitability.

Households: households will be encouraged to invest their cash rather than keep it in their bank accounts. Moderate inflation thus ensures a certain balance between the level of savings and the level of investment without which interest rates would rise.

Interest rates: moderate inflation helps to keep interest rates low. This is because the central bank that sets key interest rates does not need to affect credit conditions to achieve its monetary policy objective. This is favourable to households and companies, which will be able to borrow on attractive terms.

Too much inflation is a sign of an economic crisis. Some countries, such as Russia and Brazil, have already experienced hyperinflation, which is an excessively high and uncontrollable price increase, in the 1990s to 2000. While such situations totally disrupt a country’s economic life, disinflation policies that prove effective at the cost of wage cuts or a loss of purchasing power also present risks for social cohesion in the long term.  (EconomyMag)

Impact of the pandemic and war

Russia’s invasion of Ukraine poses risks to global financial stability and raises questions about its long-term impact on countries and markets. The war, which comes at a time when the recovery from the pandemic is already beginning to slow, will test the resilience of financial markets and threaten financial stability, as we show in the latest edition of the Global Financial Stability Report. Ukraine and Russia are the two countries facing the most pressing risks, but the severity of the disruption to commodity markets and supply chains is already known to create downside risks to macro-financial stability, inflation and the global economy.

Since the beginning of the year, financial conditions have tightened around the world, particularly in Eastern Europe. While inflation is rising, the expected increase in interest rates has led to a tightening in advanced countries in the weeks following the Russian invasion of Ukraine. Despite this tightening, financial conditions are close to their historical averages and interest rates remain accommodative in most countries.

The fact that financial conditions are difficult reduces demand. Many central banks may have to act, and more quickly than markets currently realise, to control inflation, which could push policy rates above neutral levels (a “neutral” level is one at which monetary policy is neither accommodative nor restrictive, and which allows the economy to maintain full employment and stable inflation). This situation is likely to further tighten global financial conditions. Central banks need to bring inflation back to its target rate, bearing in mind that excessive tightening of global financial conditions is detrimental to economic growth. It is in this context, and given the heightened risks to financial stability, that a sudden reassessment or revision of risk following an intensification of the war in Ukraine or an escalation of sanctions against Russia could expose some of the vulnerabilities built up during the pandemic (property price booms and excessive valuations), and cause a sharp fall in asset prices. (Gourinchas)

Inflation caused by the war in Ukraine is being felt across Europe. Eurostat reports that the inflation rate in the eurozone was 7.5% year-on-year in March. This is the highest level recorded since this indicator began in early 1997. In the previous month, it had already reached a record high of 5.9%. This is an average: it is not the same from one country to another.

My opinion on the situation

It is difficult at the moment to criticise the situation and talk about economic and political aspects when hundreds of thousands of people are affected by the war. We are currently talking about more than 3 million Ukrainians who have left their country, this is a violation of international humanitarian law. For me, this crisis is above all a social disaster, but unfortunately it will have repercussions on the world in the months to come.

As this crisis comes on the heels of a global pandemic, the economic impacts are obviously severe.

Before writing this article, I had very little knowledge of macroeconomics, but after reading several articles, watching economic videos and listening to political news, I am able to form my own opinion on the subject.

The risk of inflation is linked to disruptions in the supply chains and especially to the increase in the price of energy and raw materials coming from countries like Ukraine or Russia. At the moment and with my knowledge, the measurable impact in the short term is for the emerging countries. As I wrote earlier, these countries will experience a sharp rise in prices. In Europe, there will certainly be an impact on prices in the coming years and households are losing purchasing power, however statistics say that this could stabilise by 2023.

It has been difficult for me to remain objective in writing this article. Many of the sources I have found have strong political views. The topic is very broad and could be several articles like on supply issues. If you want to know more about the subject I encourage you to consult sources like Voxeu.org.

Cited works

EconomyMag. (s.d.). Inflation.

Gourinchas, P.-O. (s.d.). War clouds global economic outlook as inflation accelerates. IMF.

RTS, I. (s.d.).