Inflation is one of those concepts that, on its surface, seems very simple; but once you start examining it in detail, it turns out to be quite complex, after all. It is the stuff that holders of the PhD in Economics drool over. If you want to read a very nice, elegant and simple explanation of inflation, go to this article.
The basis for inflation is a simple economic truth: The more of something there is, the less it is worth. This holds equally true for diamonds, bananas, and money.
In simple terms, inflation is a measure, expressed as a rate, of how the general price of goods and services rises, and how the purchasing power of the money that you and I hold declines over time.
Do not confuse inflation and relative price changes. Inflation is a general rise in price levels, while relative price changes are usually caused by fundamental factors affecting supply and demand for given products and services. Examining the changes over a given period of time in the price of gasoline, or steaks, or diapers, does not tell us much about inflation, or about deflation, either.
There are numerous theories to explain inflation, and here are two of them:
1. Cost-Push Inflation refers to a sudden rise in the cost of production, with demand for products or services decreasing or remaining the same. The additional cost is transferred to buyers in the form of price increases.
2. Demand-Pull Inflation refers to the existence of too much money and too few goods. It results when there is a shortage of supply, and the economy demands more goods and services than what is available. This results in price increases, which will remain until the supply can finally match up to the demand and maintain the balance. This usually happens to growing economies.
Governments who use fiat currency are especially prone to inflation (monetary inflation) because they are tempted to increase the money supply / decrease the value of money in order to meet foreign debt obligations, or for other reasons. History is littered with many sad stories of countries such as Weimar Germany, Zimbabwe, Argentina and others that have experienced periods of extra-ordinary inflation (hyper-inflation: generally considered to be a rate of 50% per month or more). The depreciation of money caused by inflation causes a loss in buying power, which in turn lowers the demand for goods and services. Weaker demand results in weaknesses in the goods and services market, which in turn leads to layoffs and growing unemployment.
The onset of inflation often leads to behaviors that make the problem worse, as consumers engage in hoarding, a behavior in which people buy more than what they need of a commodity because they fear the price will rise.
People on fixed income and lenders are more negatively affected by inflation because they cannot adjust to changes in the value of money as easily as people whose incomes are flexible. Borrowers profit from inflation because they are able to pay back debt in devalued currency.
Central banks have the task to be on guard for inflation, which is a kind of tax that can quickly suck the vitality from the strongest economy. In the United States, the Federal reserve has the task of fighting inflation.
The Federal Reserve recognizes that there are four basic ways in which high inflation negatively impacts an economy:
A. Sustained high inflation erodes the purchasing power of people on fixed incomes.
B. High inflation can lead consumers and producers to spend time managing its effects. Producers must change prices frequently, and consumers spend more time trying to manage their cash holdings.
C. High inflation confuses price signals about supply and demand, which leads to inefficient spending decisions.
D. High inflation creates adverse tax effects that could cause consumers and producers to make decisions they might not otherwise make. This results from the fact that many federal and state tax codes are not indexed to inflation.
There are problems created by very low inflation, as well. When inflation is very low, the Federal Reserve's ability to ease monetary policy during recessionary or near-recessionary periods is severely limited if the federal funds rate cannot be lowered any further. Deflation, which occurs when the overall price level falls as inflation rates turn negative for an extended period, can have serious negative effects on an economy; when prices are expected to continue falling, consumers and producers tend to delay purchases while waiting for lower prices, which place additional downward pressure on the economy.
There are a number of ways to estimate inflation; in the United States, the Consumer Price Index (CPI) is a popular gauge of inflation. The CPI is generated by the Bureau of Labor Statistics. It is logical that the BLS should measure inflation, as inflation is closely correlated to unemployment rates and wages. HOWEVER, many economists believe that the CPI is actually a very poor gauge of inflation because of weighting biases and what is called "transitory noise" created by non-monetary events and sampling errors.
The Federal Reserve is also concerned with consumer expectations about inflation. One method of gauging such expectations is to use a survey, such as the Reuters/U. of Michigan Surveys of Consumers: these ask consumers how much they think prices will change generally without considering any statistics. There is also something called the "break-even" inflation rate, which is gotten by averaging together the interest rates on two different types of Treasury securities.
Last updated 11/30/11
The basis for inflation is a simple economic truth: The more of something there is, the less it is worth. This holds equally true for diamonds, bananas, and money.
In simple terms, inflation is a measure, expressed as a rate, of how the general price of goods and services rises, and how the purchasing power of the money that you and I hold declines over time.
Do not confuse inflation and relative price changes. Inflation is a general rise in price levels, while relative price changes are usually caused by fundamental factors affecting supply and demand for given products and services. Examining the changes over a given period of time in the price of gasoline, or steaks, or diapers, does not tell us much about inflation, or about deflation, either.
There are numerous theories to explain inflation, and here are two of them:
1. Cost-Push Inflation refers to a sudden rise in the cost of production, with demand for products or services decreasing or remaining the same. The additional cost is transferred to buyers in the form of price increases.
2. Demand-Pull Inflation refers to the existence of too much money and too few goods. It results when there is a shortage of supply, and the economy demands more goods and services than what is available. This results in price increases, which will remain until the supply can finally match up to the demand and maintain the balance. This usually happens to growing economies.
Governments who use fiat currency are especially prone to inflation (monetary inflation) because they are tempted to increase the money supply / decrease the value of money in order to meet foreign debt obligations, or for other reasons. History is littered with many sad stories of countries such as Weimar Germany, Zimbabwe, Argentina and others that have experienced periods of extra-ordinary inflation (hyper-inflation: generally considered to be a rate of 50% per month or more). The depreciation of money caused by inflation causes a loss in buying power, which in turn lowers the demand for goods and services. Weaker demand results in weaknesses in the goods and services market, which in turn leads to layoffs and growing unemployment.
The onset of inflation often leads to behaviors that make the problem worse, as consumers engage in hoarding, a behavior in which people buy more than what they need of a commodity because they fear the price will rise.
People on fixed income and lenders are more negatively affected by inflation because they cannot adjust to changes in the value of money as easily as people whose incomes are flexible. Borrowers profit from inflation because they are able to pay back debt in devalued currency.
Central banks have the task to be on guard for inflation, which is a kind of tax that can quickly suck the vitality from the strongest economy. In the United States, the Federal reserve has the task of fighting inflation.
The Federal Reserve recognizes that there are four basic ways in which high inflation negatively impacts an economy:
A. Sustained high inflation erodes the purchasing power of people on fixed incomes.
B. High inflation can lead consumers and producers to spend time managing its effects. Producers must change prices frequently, and consumers spend more time trying to manage their cash holdings.
C. High inflation confuses price signals about supply and demand, which leads to inefficient spending decisions.
D. High inflation creates adverse tax effects that could cause consumers and producers to make decisions they might not otherwise make. This results from the fact that many federal and state tax codes are not indexed to inflation.
There are problems created by very low inflation, as well. When inflation is very low, the Federal Reserve's ability to ease monetary policy during recessionary or near-recessionary periods is severely limited if the federal funds rate cannot be lowered any further. Deflation, which occurs when the overall price level falls as inflation rates turn negative for an extended period, can have serious negative effects on an economy; when prices are expected to continue falling, consumers and producers tend to delay purchases while waiting for lower prices, which place additional downward pressure on the economy.
There are a number of ways to estimate inflation; in the United States, the Consumer Price Index (CPI) is a popular gauge of inflation. The CPI is generated by the Bureau of Labor Statistics. It is logical that the BLS should measure inflation, as inflation is closely correlated to unemployment rates and wages. HOWEVER, many economists believe that the CPI is actually a very poor gauge of inflation because of weighting biases and what is called "transitory noise" created by non-monetary events and sampling errors.
The Federal Reserve is also concerned with consumer expectations about inflation. One method of gauging such expectations is to use a survey, such as the Reuters/U. of Michigan Surveys of Consumers: these ask consumers how much they think prices will change generally without considering any statistics. There is also something called the "break-even" inflation rate, which is gotten by averaging together the interest rates on two different types of Treasury securities.
Last updated 11/30/11