Inflation Explained: Why Prices Rise and What It Means for You
Introduction
Inflation. We, as consumers, have all felt it before. The little thought that comes up in the back of our minds when we are shopping, thinking ‘Wasn’t that box of cereal $2 cheaper just a couple of months ago?’ The rising prices and just the overall feeling of a seemingly more expensive world.
In definition, inflation is the loss of the purchasing power of money due to a gradual increase in prices. To make it easier to understand, imagine a candy shop. Imagine one year you have $1 and the cost of a rainbow lollipop is also $1. You can successfully purchase it. Now the next year rolls along and you head into the same shop to buy the same lollipop with only a dollar. But now, the rainbow lollipop is selling for $2. You don’t have enough. Even though you have the same amount of money you had previously, this rise in the price of the good has left you able to buy only ½ of the lollipop (they probably won’t let you do that though). So, the money can be seen as essentially being ‘worth less.’
Causes of Inflation
As with most economic concepts, inflation has its fair share of complexities when it comes to discussing what causes it.
- Demand-pull Inflation: Increased demand for goods and services that outweighs the supply which usually results in shortages and an upward surge in prices.
- Cost-push Inflation: Rising costs in production are usually due to an increase in the cost of wages and raw materials. So, supply decreases and the price increases are pushed onto consumers.
- Price-Wage Spiral: ‘downward’ spiral where workers ask for raises to combat inflation, these higher wages lead to higher costs for the employer, the employers push costs down onto the consumers, the consumers (including the workers) see prices rise, and the cycle repeats from the top.
- Monetary Inflation: the government increases the money supply causing inflation usually to stimulate the economy.
How Do We Measure It?
So with something as impactful as Inflation in our daily lives, we need a way to track it. And while there are many different methods, the Consumer Price Index (CPI) turns out to be a simple, yet effective method to gauge inflation. The CPI tracks the overall change over time in consumer prices based on a representative basket of goods and services. It is regularly used by economists to measure inflation, businesses to create future models, and even the Federal Reserve for shaping its monetary policy.
Effects on the Consumer
Now, arguably the most important part, we take a dive into how it affects you, the consumer. There are a multitude of effects, some good for some, others bad for others.
The erosion of purchasing power is one that almost directly originates from the definition of inflation itself. It is simple: if the value of your money is decreasing, then that same money will buy fewer and fewer goods and services as time goes on.
The most notable effect inflation has on all consumers is the higher prices. For example, higher prices tend to disproportionately affect lower-income individuals and families, making it even more difficult to buy essential items. Take a look at the infographic below for the inflation’s impact on the price of a cup of coffee over time as an example of the general increase in prices we see for even the simplest items:
Similarly, inflation can potentially hurt savings and investments. Since inflation lowers the value of money, things like cash savings accounts and liquid assets can be directly and adversely impacted by an increase in inflation.
To fight against rising inflation, the government usually increases interest rates (monetary policy). Since interest rates play a vital role in large consumer purchases like vehicles and homes, large interest rates usually make it harder to afford and even deter some consumers from taking on loans and borrowing money. Additionally, higher interest rates usually decrease the price of bonds, making them less valuable.
High Inflation paired with the dangerous combo of slow economic growth (stagnation) and a high unemployment rate can lead to an economic cycle known as Stagflation. Take the 1970s Oil Crisis as an example: new embargoes placed on Western nations’ oil dramatically increased prices and costs for businesses. This led to unemployment as businesses tried to cut costs by getting rid of workers, high inflation as businesses passed higher costs down to consumers, and slow economic growth since less oil meant less production.
When people think about negative economic events in U.S. history, one of the first things to come to mind is the Great Depression, one of the most severe and impactful economic downturns that had influences globally. The Great Depression was a recession. And while hopefully something like it does not happen again for a long time to come, it still is a prime example to take a look at inflation’s impact on our economic cycle, particularly regarding recessions. Ignoring stagflation for a second, there is almost a tradeoff relationship between inflation and unemployment. So in the government’s process of trying to maintain low unemployment, inflation is sometimes left unchecked and able to grow to larger than ‘safe’ values. Consequently, high inflation can lead to some of the same effects previously mentioned, most of them negative for consumers and producers.
While all of these effects are significant and essential to consider, it is important to remember that even if inflation is on the rise, things like Stagflation and recessions are not constantly occurring like yearly scenarios. There could be years before the next recession hits or maybe even decades before we experience heavy stagflation again. And like most things in economics, these cycles don’t happen without reason. Stagflation is speculated to have been primarily caused by things like oil shocks, poor economic policies, and even the loss of the gold standard. Recessions are similar and need certain triggers to throw the self-checking balance out of hand. For example, the dot-com bubble crash, the bursting of the housing bubble in 2008, and the COVID-19 pandemic, just to name a few, all had pretty big triggers and lead-ups before the recessions.
Conclusion
Inflation is just a normal part of our economy. It can be bad if it’s too high. It can be good if it’s low and stable, sometimes even spurring economic growth. That’s why it is crucial to monitor inflation because both it alone and in combination with other factors can impact the lives of many. Understanding such a key economic indicator is not only for businesses, the government, and investors, it is for regular consumers and people to recognize and react to for their own well-being.
But the future is still ahead of us. We are advancing like never before. New technology, new healthcare, and new everything causing unprecedented growth that is still yet to be fully understood. Questions like how to manage inflationary pressures without stifling growth, adapting to new scenarios on the domestic and global stage, and ensuring long-term stability will all need to be answered as we move forward. But we have done it in the past as we adapted and thrived in our current situations, so I believe we will turn out just fine.
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