What is inflation?
Inflation is a term that frequently pops up in economic discussions. But what exactly is it, and why does it matter? Let’s dive into rising prices, shrinking purchasing power, and the impact it has on our wallets.
At its core, inflation refers to the general increase in prices of goods and services. You can afford fewer goods and services than you did before. This means you are losing purchasing power over time. An example of this is buying a snack at a vending machine. I remember several years ago, a bag of chips used to be $1 at the vending machine. The other day, I saw a vending machine charging $2.50 per bag! In this case my purchasing power has decreased because the same $1 can now get me less chips.
How do you measure it?
Measuring inflation allows you to understand how much purchasing power you have lost over time. The consumer price index (CPI) is a common measure of inflation, and it measures the average price for goods and services like groceries and rent. The Bureau of Labor Statistics publishes the CPI every month, here is their website.
You can generally look at the CPI to understand how your purchasing power has changed over time. For example, if the CPI is 3.8% since last year, this means every $100 you have can now afford what $96.20 could have gotten you a year ago.
Why does inflation happen?
There are a lot of reasons why inflation occurs, and we won’t get into all those reasons in this blog. Here are some basic reasons:
Demand pull: This means demand for goods/services exceeds supply. Some reasons why demand-pull happens include high consumer confidence. When consumers have a positive outlook on the economy (because of low interest rates, affordable housing market, strong job market) they tend to spend more. When people spend more, businesses can now afford to raise prices. This increase in prices causes inflation.
Cost push: When the cost of producing a good increases, businesses often pass those costs over to consumers. This can happen for a variety of reasons. An example of cost-push would be if a major supply chain issue raised the per unit price of transported goods. Historically, businesses make their customers pay for this increase in raw material by raising prices on finished goods.
World events: Natural disasters, pandemics, wars, and more can lead to inflation. Wars often cause global supply chain issues, which can lead to inflation worldwide. Basically, if it impacts supply and demand for goods/services, most likely it will impact inflation.
Is inflation always bad?
No, it’s not always bad. In fact, some inflation is actually pretty good for the economy. When inflation is predictable and controllable, it can encourage consumer spending in a positive way. This is because when inflation is moderate, consumers feel they can get a good deal on goods/services. This leads to consumers spending more money. When consumers spend money, businesses grow (along with employment) and the economy grows. This leads to a higher standard of living for society. Of course, we don’t want too much of a demand-pull effect I described earlier. But some demand-pull is beneficial for economic growth.
While some inflation is good, deflation (the opposite) is bad! Deflation is the steady decrease in prices. Although this sounds pleasant, it can be very detrimental. Deflation discourages businesses from investing in new products/projects. This is because their product/project will be worth less money in the future due to deflation. When companies don’t invest in new products/projects, they fire people whose jobs have now become obsolete. This increases the unemployment rate.
Also, deflation can make it harder for consumers to pay back debt. This is because while prices are falling during deflation, your past debt stays fixed! The value of your money increased with deflation, and so the value of your debt is higher too.
Here is an example: I borrow $10,000 from the bank to finance a car. Then, deflation has decreased price levels by 10%.This means my car is now worth $9,000, but I still have to pay $10,000 for it. Prices are decreasing, but I am still paying higher prices because of my fixed debt.
Here’s where the Federal Reserve comes in
While high inflation is generally harmful, the downsides of deflation prove to be detrimental. But how do you assure inflation is in the goldilocks zone? That’s the job of the Federal Reserve. The Federal Reserve is a government agency that changes interest rates to control inflation. Depending on whether the goal is to increase or decrease inflation, the Federal Reserve can change interest rates to impact the supply and demand of goods/services. The Federal Reserve generally targets 2% inflation to keep business profitable while also keeping consumers purchasing power. In another blog, we’ll talk in more detail about how the Federal Reserve does this.
Conclusion
Inflation is the general increase in prices of goods and services. Deflation is the exact opposite, the general decrease in prices of the same goods and services. It’s important to know what inflation/deflation are because they impact your cost of living and the health of the economy. While too much inflation is bad, deflation is also detrimental. Ideally, inflation is around 2% to assure steady economic growth.
In the grand scheme of things, you may feel like you can do nothing to combat excessive inflation. The best thing to do is to stick to a budget so that your expenses don’t increase linearly with inflation. You can also invest some of your money rather than keep it all as cash. This is because cash loses value with inflation.
A third thing you can do is follow along my blogs where I’ll continue to post about all things personal finance!