In January of 2002, the price of one gallon of gasoline was one dollar and 44 cents, today the national average is over five dollars per gallon and is expected to go much higher in the coming year.
This is a big jump in price in the last 20 years but if we take a moment to look back, everything has gotten more expensive over time food, clothing, housing, transportation, and everything in between. This is due to a phenomenon called inflation.
Definition
So what is the definition of Inflation?
At a basic level, we know that inflation means that things get more expensive over time. But do we actually understand it, where does inflation come from, are there different types of inflation, and what does high inflation like what we’re seeing now in the US mean for the future of our economy?
History/Origin
To understand inflation we must understand how it was created in the first place.
It all started in 1971. before then gold was real money and it was used in transactions between countries. Paper money was like a check on a checkbook. That it really had no value other than to be exchanged for gold, but we ran into a problem they ran out of money.
The government printed and spent a lot more paper money than they had in gold this was like writing a check without actually having all the funds in the bank account. The US was in trouble and people holding dollars rushed to exchange their paper money for gold before gold ran out. It became apparent that the US could not pay all of its paper money back.
The US knowing that they will run out of money had an idea, and on August 15, 1971, President Nixon announced that the US dollar will no longer be connected to gold.
That was the day the nature of money changed in the US. The economy went from the gold standard to what is now known as fiat money a devaluating currency. This new money is not attached to any commodity. The value of the dollar is based on the trust of those using it and the flow of money is controlled by the Federal Reserve or the fed which is the central bank of the united states.
Role of Central Bank / Federal Reserve
What central bank or federal reserve do ?–The central bank is like the bank for banks that are where normal banks go to borrow money to then lend to you.
The central bank also controls the creation and flow of new money into the economy and since money is now its own entity, and isn’t attached to any commodity this means that this new flow of money creates inflation. Inflation might sound scary since it makes the price of goods and services go up but in this new economy. Inflation isn’t really a bad thing.
A small amount of inflation is actually a good indication of a growing economy. inflation typically happens when people have more money because it leads to more spending.
In the words of investor Ray Dalio
Quote
Someone spending is someone else’s income in an economy with more spending incomes tend to increase this also means more demand for products and services which can lead to higher productivity.
In other words, businesses are able to create more goods for more people. This is what is called the GDP or the gross domestic product.
So what is the GDP of a country mean? – This measures the monetary value of the goods produced in the country, in simple words measures the productivity of the country.
The increase in demand results in higher prices resulting in inflation. Now a small amount of inflation is a good thing, the federal reserve aims to have a two percent inflation rate per year for a healthy economy but what happens when inflation gets out of control?
Also read –The Intelligent Investor – The Ultimate Book Summary
Can high inflation destabilize the economy?
Effects of Inflation on Economy
In order to understand the effects of inflation on the economy, we must understand the different types of inflation and what causes them.
- Cost-push inflation-
is when the cost to run a business increases and those costs get passed down to the customer. This is affected/caused by a variety of reasons like an increased cost of materials, a shortage of supply or labor, increased employee salary, or a combination of them which can create supply chain issues like what we’re seeing currently in the US.
This will increase the operating costs of running a business causing prices to increase aka inflation.
- Demand pool inflation-
can be considered a good type of inflation, this has to do with supply and demand. When people have more money there is more demand for products and services which leads businesses to increase their prices but there’s a dark side to demand poll inflation, what people call built-in inflation.
This type of inflation is influenced by human behavior if people believe there will be high inflation. In the near future, they might rush to buy goods and services before the price increases. This creates a sharp increase in demand for these goods and services leading prices to increase creating an inflation bubble.
- High money supply inflation-
is when the government increases the supply of new money entering the economy, this can happen in a few forms. The government can simply create more money and inject it into the economy either by creating stimulus packages that are given to citizens or companies or by what is called quantitative easing (Sometimes also known as helicopter money). This is when the government buys financial securities like bonds from the open market with newly created money.
This helps increase the flow of new money into the economy. This is usually done to stimulate the economy in times of economic recession as we saw in 2008 and recently in 2020. This new creation and injection of money are done to create more demand for goods and services. That can stimulate more productivity and help the country get back on track, but it creates inflation as a byproduct.
There is a risk to this method and is one of the reasons why the government usually only does it in times of economic crisis.
If too much money is thrown into the economy it can lead to over-inflation. Since there’s too much money productivity will not be able to keep up with demand. So the creation of new money is a big balancing act for the federal reserve.
Too much to one side and we have hyperinflation too much to the other and we have a recession.
Interest Rate’s role in Economy during Inflation
Another way the government puts more money into the economy is when the central bank lowers interest rates. Now, this raises two questions here.
What happens when the central bank / Fed decreases interest rates?
Why does the central bank / Fed decrease interest rates?
By lowering, interest rates borrowing money becomes cheaper and more attractive for borrowers. This leads people to borrow more money which increases the money supply in the economy and more money in the economy means more demand, increased productivity, and inflation.
Again inflation is a good thing in the economy but only in small doses. When inflation gets out of control it can create many economic problems. During times of high economic inflation, especially those caused by unexpected events like supply chain issues caused by a pandemic, for example, wages don’t grow on par with inflation. This means people are not making more money but their money has less buying power than before. This can put pressure on the economy as consumers begin paying more and more for the same goods.
Which people get most affected due to inflation?
High inflation affects low-income earners the most since they are the ones using a bigger portion of their incomes for their basic needs.
Another side of Inflation.
What happens when the central bank / Fed increases interest rates?
Why does the central bank / Fed increase interest rates?
To slow down the growth of inflation the government typically begins raising interest rates on borrowed money, as we saw recently in the US.
This leads borrowing money to be more expensive so people begin to borrow less and spend less money.
Less spending slows down demand helping prices come down essentially cooling down an overheated economy. This can be a complicated process for the central bank. If interest rates go too high too fast can lead to a recession since spending goes down significantly people stop buying goods and services. This means businesses make less money with less money, businesses have to cut down on their own expenses by scrapping projects or plans for expansion which eventually can lead to layoffs and higher unemployment leading to a recession.
The central bank typically increases rates slowly in small increments to avoid this from happening although there’s only so much the central bank can do to control inflation. Because there are some causes of inflation that are not directly related to the money supply in the economy.
Many experts believe that a big part of our current inflation is a combination of the over-creation of new money and supply chain issues caused by the pandemic.
Where Material personnel and transportation are insufficient to keep up with the demand for goods and services causing prices to stay up until these issues are fixed.
But what do you think are we at the brink/edge of a recession or the central bank be able to balance the money supply to keep us from falling into an economic crisis?
Let me know in the comments section below.