Explain It Like I'm Five (ELI5)
Ever hear your grandmother talk about how everything was cheaper when she was younger? That’s because of inflation. It’s caused by irregularities in supply and demand for products and services, leading to an increase in prices.
It has its advantages, but overall, too much inflation is a bad thing: why would you want to save your money if it’s going to be worth less tomorrow? To control inflation when it gets too high, governments deploy policies that aim to reduce spending.
Inflation can be defined as the reduction of the purchasing power of a given currency. It’s the sustained increase in the price of goods and services in an economy.
While “relative-price change” usually means just one or two goods have increased in price, inflation refers to an increase in costs of nearly all items in the economy. Also, inflation is a long-term phenomenon – the increase in prices has to be sustained, and not just a sporadic event.
Most countries perform annual measurements of inflation rates. Generally, you’ll see inflation expressed as a percentage change: its growth or decline relative to the previous period.
In this article, we’ll go over the different causes of inflation, ways to measure it, and the impacts (both positive and negative) that it can have on the economy.
On a basic level, we can describe two common causes of inflation. First, a rapid increase in the amount of actual currency in circulation (supply). For instance, when European conquistadors subjugated the western hemisphere in the 15th century, gold and silver bullion flooded into Europe and caused inflation (the supply was too high).
Second, inflation can occur due to a supply shortage in a specific good that is in high demand. This can then spark a rise in the price of that good, which may ripple through the rest of the economy. The result can be a general rise in prices across nearly all goods and services.
But if we dive deeper, we can describe different kinds of events that may lead to inflation. Here, we’ll distinguish between demand-pull inflation, cost-push inflation, and built-in inflation. There are other variations, but these are the major ones in the “triangle model” proposed by economist Robert J. Gordon.
Demand-pull inflation is the most common kind of inflation, caused by an increase in spending. In this instance, demand outweighs the supply of goods and services – a phenomenon that causes prices to rise.
To illustrate this, let’s consider a marketplace where a baker sells his goods. He can produce approximately 1,000 loaves of bread per week. This works well, as he sells roughly that amount every week.
But suppose then that there’s a massive increase in the demand for bread. Perhaps economic conditions have improved, meaning that consumers have more to spend. As such, we’re likely to see the price of the baker’s loaves increase.
Why? Well, our baker is operating at full capacity when he makes the 1,000 loaves. Neither his staff nor his ovens can physically produce more than that number. He could build more ovens and hire more staff, but this takes time.
Until then, we have too many customers and not enough bread. Some customers will be willing to pay higher prices for a loaf, so it’s only natural that the baker increases his pricing accordingly.
Now, apart from the increased demand for bread, imagine that the improved economic conditions also led to a higher demand for milk, oil, and several other products. This is what defines demand-pull inflation. People are buying more and more goods in a way that demand outpaces supply – causing prices to rise.
Cost-push inflation occurs when price levels rise as a result of increased raw material or production costs. As the name suggests, those costs are “pushed” to the consumer.
Let’s revisit the baker from earlier. He’s built his new ovens and hired additional staff to produce 4,000 loaves of bread a week. For the moment, the supply caters to the demand, and everybody’s happy.
One day, the baker gets some unfortunate news. The wheat harvest has been particularly bad this season, meaning that there’s not enough supply to go around all the bakeries in the region. The baker must pay more for the wheat needed to produce the loaves. With this added expenditure, he needs to raise the prices he charges, even though consumer demand hasn’t increased.
Another possibility is that the government increases the minimum wage. This adds to the baker’s production costs, so, once again, he must raise the prices of the completed loaves.
On the grand scale, cost-push inflation is often caused by shortages in resources (like wheat or oil), increased government taxation on goods, or falling exchange rates (resulting in imports costing more).
Built-in inflation (or hangover inflation) is a type of inflation that arises from past economic activity. As such, it can be triggered by the previous two forms of inflation if they persist over time. Built-in inflation is closely related to the concepts of inflationary expectations and price-wage spiral.
The first describes the idea that – after periods of inflation – individuals and businesses expect inflation to persist in the future. If there was inflation in the previous years, employees are more likely to negotiate higher salaries, causing businesses to charge more for their products and services.
The price-wage spiral is a concept that illustrates the tendency of built-in inflation to cause more inflation. It may occur when employers and workers can’t reach an agreement on the value of their wages. While workers demand higher wages to protect their wealth from expected inflation, employers are forced to increase the costs of their products. This may lead to a self-reinforcing cycle, where workers demand for even higher salaries in response to the increased costs of goods and services – and the cycle continues.
Unchecked inflation can be damaging to the economy, so it stands to reason that governments take a proactive stance in limiting its impact. They can do this by tweaking the money supply and making changes to monetary and fiscal policy.
Central banks (like the United States Federal Reserve) have the power to alter the fiat money supply by increasing or decreasing the amount in circulation. A common example of this is quantitative easing (QE), where central banks purchase bank assets to infuse the economy with freshly-printed money. This measure can actually aggravate inflation, so it isn’t used when inflation is the issue.
The opposite of QE is quantitative tightening (QT), which is a monetary policy that can reduce inflation by decreasing the money supply. However, there is little evidence that supports QT as a good remedy to inflation. In practice, most central banks control inflation by raising the interest rates.
Higher interest rates make it more expensive to borrow money. As a result, credit becomes less attractive to consumers and businesses. At the consumer level, increased interest rates will discourage spending, causing demand for goods and services to decrease.
It becomes attractive to save during these periods, and even better for those that lend money to earn interest. However, the economy’s growth might get constrained, as businesses and individuals are more cautious of taking out credit to invest or spend.
While most countries make use of monetary policies to control inflation, altering fiscal policy is also an option. Fiscal policy refers to the governments’ spending and adjustment of taxes to influence the economy.
If governments increase the income tax they collect, for example, then individuals once again have less disposable income. In turn, there’s less demand in the market, which should theoretically reduce inflation. However, this is a dangerous route to take, as the public might react unfavorably to higher taxes.
So we’ve outlined the measures to combat inflation, but how do we actually know that it needs combatting in the first place? The first step, evidently, is to measure it. Typically, this is done by tracking an index over a set period of time. In many nations, a Consumer Price Index (or CPI) is the go-to measure of inflation.
A CPI takes into account the prices of a wide variety of consumer products, using a weighted average to value a basket of items and services bought by households. This is done every so often, and the score can then be compared with historical ones. Entities like the US’s Bureau of Labor Statistics (BLS) collect this data from stores all around the country to ensure their calculations are as accurate as possible.
You might look at a CPI score of 100 for the “base year” in your calculation, and then at a score of 110 two years later. You could then reach the conclusion that, over two years, prices have increased by 10%.
A small amount of inflation isn’t necessarily a bad thing. It’s a natural occurrence in the fiat currency systems of today and is somewhat beneficial as it encourages spending and borrowing. Keeping a close eye on the rate of inflation is important, however, to ensure that it doesn’t have any negative effects on the economy.
At first glance, inflation may appear to be something worth avoiding altogether. But it remains part and parcel of modern economies, so it’s a much more nuanced subject in reality. Let’s look at some of the advantages and disadvantages.
As we touched on earlier, a low rate of inflation can benefit the economy by stimulating spending, investment, and borrowing. It makes more sense to acquire goods or services immediately, as inflation makes it so that the same amount of cash will have reduced purchasing power in the future.
Inflation prompts companies to sell their goods and services at higher prices, so as to protect themselves from the effects of inflation. They can justify these increases, but they can also raise prices a bit higher than needed to pocket additional profits.
As you might guess from the name, deflation is the opposite of inflation, marked by a decrease in prices over time. Since prices are falling, delaying purchases makes more sense to consumers, as they can get better prices in the near future. This can negatively impact the economy, as there isn’t as much demand for goods and services.
Historically, periods of deflation have resulted in higher unemployment rates and a shift towards saving instead of spending. While not necessarily a bad thing for the individual, deflation tends to hinder economic growth.
Finding the right rate of inflation is difficult, and failing to control it can yield catastrophic consequences. Ultimately, it erodes the wealth that individuals hold: if you store $100,000 in cash under your mattress today, it won’t have the same purchasing power in ten years.
High inflation can lead to hyperinflation, which is said to occur when prices rise by more than 50% in one month. Paying $15 for a basic necessity that only cost $10 weeks prior isn’t ideal, but it rarely stops there. In periods of hyperinflation, prices often far exceed the 50% rate, essentially destroying the currency and the economy.
If inflation rates are high, uncertainty can take hold. Individuals and businesses are unsure of where the economy is heading, so they’ll be more cautious with their money – leading to less investment and less economic growth.
Some are opposed to the idea of the government attempting to control inflation, citing free-market principles. They argue that the government’s ability to “create new money” (or Brrrrr, as it’s popularly known in cryptocurrency circles) undermines natural economic principles.
The effects of inflation are such that we witness prices increase over time, causing the cost of living to rise. It’s a phenomenon that we’ve come to accept – after all, if it’s controlled correctly, inflation can be beneficial to the economy.
In today’s world, the best remedies appear to lie in flexible fiscal and monetary policies, which allow governments to adapt to keep rising prices in check. However, these policies must be very carefully implemented, or they could end up causing further damage to the economy.
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