Economics 101: What is Inflation?

Inflation, simply put, is the rise in the price of goods over a period of time. When grandparents recount how little bread or cars cost when they first began working, they’re talking about the phenomenon of inflation. Many things can drive up the costs of certain goods in the short or long-term and inflation refers to a rise in the general cost of all goods in the market place. It’s typically measured with a general price index, such as the Consumer Price Index. Inflation can have several effects on an economy, both good and bad.

How is Inflation Calculated?

Inflation over any period is calculated by the difference between a current price index and the same index at the beginning of the period. That difference is then divided by the index at the beginning of the period. For example, let’s say that a given index is currently 110 and was 100 one year ago. The inflation rate, according to that index, would (110-100=10)/100= 10%. There are any number of price indices that can be used to calculate inflation. The Consumer Price Index is most common, and others include producer price indices (which measure prices producers receive for their goods) and commodity indices.

How Does Inflation Effect the Economy?

The most well known negative effect of inflation is the erosion of purchasing power. As goods cost more and more, a dollar is worth less and less. This is why some people say you lose money by keeping cash wedged underneath your mattress: if it isn’t earning interest, it’ll be worth less and less as time goes on. Economists refer to this as a loss in the real value of money.

Consumers may also begin hoarding certain non-perishable goods as a hedge against inflation. Consumers very worried about inflation are known to purchase gold or silver, for example. In extreme cases, this can create shortages in the relevant goods. High inflation is also known to discourage savings and investment.

A more common scenario in which inflation is harmful is the case of individuals on fixed incomes. If an individual’s income does not rise with inflation, they will essentially see themselves get poorer and poorer every year.

Inflation can, however, have a few good effects for an economy. For one, it allows for some flexibility of interest rates. One way to stimulate a lagging economy is to lower interest rates. Without any inflation, nominal interest rates—the ones charged by the bank—might not be able to be lowered enough to stimulate an economy out of recession. In that sense, inflation helps keep nominal rates high enough for some flexibility. (The term real interest rate refers to a nominal interest rate minus the rate of inflation.)

Inflation can also put certain consumers in an advantageous spot. Say, for example, that you have a mortgage locked in at a low percentage rate. If your wages keep up during a time of high inflation, you will find yourself paying a much smaller portion of your real income on your mortgage.

What Causes Inflation?

Most economists agree that high rates of inflation are caused by rapid growth of the money supply. In other words, if the government prints more money, the worth of currency already in circulation will drop. For a far out historical example, read about the Weimar Republic, the government of Germany before World War II. Faced with massive war debts, the country continued to print money until it became literally worthless. Citizens used it to start fires because it was worth less than the paper it was printed on. That’s not something most economists worry about happening now, as it would require printing very large amounts of money and the Federal Reserve would never let that happen.

Hyperinflation is caused by rapid growth in the money supply. As for what causes typical levels of inflation, that leaves more room for debate. Some theorize that inflation is caused by growth in demand across an entire market. Others theorize that increased cost of certain goods due to lagging supply may cause inflation. We see this when oil prices rise, causing shipping costs to rise with them.

There’s very little most consumers can do about inflation, at least in terms of stopping or slowing it. But there are ways to plan your investment strategy around inflation. Talk to your investment advisor if you’re worried about planning for inflation. If your investments keep up with a growing economy, you’ll have no problem finding success in the future.

Published or Updated: March 15, 2013
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. The relationship between inflation and gasoline prices is directly proportional. Inflation has numerous effects to the economy-whether good or bad.

Speak Your Mind

*