Beginner’s Guide to Inflation
This guide will introduce you to the basic causes of inflation, discuss its role in the economy and explain its significance for consumers.
September 20, 2021
The Federal Reserve printed over $2.8 trillion in 2020 to fund stimulus efforts in response to COVID-19. That means over 40% of the cash in circulation at the beginning of 2021 was printed in the twelve months prior.
With such a dramatic increase in the money supply, many Americans are concerned about an impending inflation surge.
To help you understand what that could mean, this guide will introduce you to the basics of inflation, discuss its role in the economy, and explain its significance for consumers.
What is inflation?
Inflation is the steady increase of prices over time in an economy, which gradually erodes the underlying currency’s purchasing power.
Most often, you’ll see inflation expressed as a percentage rate based on one of the following indexes:
Cost Price Index (CPI): This is the most popular method of measuring inflation and you’ve probably heard it mentioned before. It tracks changes in the prices of eight types of goods and services available to urban households: housing, food and beverages, transportation, healthcare, education, apparel, communication and recreation.
Personal Consumption Expenditures (PCE): This is the Federal Reserve’s preferred method for measuring inflation. Instead of tracking the change in prices of goods and services, it measures the changes in total consumer spending, which is a more direct way of gauging the cost of living.
Both methods have their merits. The CPI allows for a more detailed breakdown of inflation on specific goods and services.
Meanwhile, the PCE paints a broader picture by including more consumers (not just urban households) and their spending on more than just the goods and services measured by the CPI.
It also provides deeper insight into the economy, since it tracks how consumers spend their money and what they’re spending it on.
How does inflation work?
Inflation might not seem super apparent to the average consumer in their day-to-day life. It’s a gradual, inconsistent process that’s understood as an average trend over large swathes of goods and services.
If you were to track the price of avocados at your local grocery store, you might find that they’re $0.79 in January, $0.85 in June, then $0.75 in December.
Based on that trend, you might be surprised to learn that the average price of avocados in the country rose by 2% over the same time period, but it could likely be the case.
What clouds matters further is that many goods and services are substitutable, and consumers have a natural tendency to seek cheaper alternatives if the price of their goods or services increases.
If your barber increases how much he charges for a haircut beyond what you’re willing to pay, you can switch to another one at a more acceptable price point.
These obscuring factors reinforce the idea that inflation works as a general erosion of purchasing power, not a consistent increase in the cost of an individual good or service.
How does inflation affect the economy?
Inflation might be scary to some people, but it’s part of economic growth. In fact, moderate levels of inflation are an indication of a healthy economy.
One of the Federal Reserve’s primary responsibilities is to maintain price stability, which they interpret as keeping inflation at a low and steady rate. Specifically, they aim for an annual average of 2%.
That steady public target for inflation is necessary for economic stability and proper consumer financial planning. If inflation strays too far from the intended goal in either direction, it can have widespread negative impacts.
Too much inflation erodes the value of cash faster than wages can keep up and punishes people for saving. Low or negative inflation (deflation) can stagnate wages, contribute to unemployment and encourage consumers to hoard cash.
At extreme levels, these problems can break an economy. Hyperinflation, often defined as an average inflation rate of 50% per month (Venezuela is a good example), will cause the underlying currency to basically become worthless.
Natural causes of inflation
Inflation is a natural occurrence in most economies, especially once consumers come to expect it. The three most common causes of inflation are:
Cost-push inflation: This occurs when production costs for a good or service increase faster than demand. For example, if the cost of the raw materials in cars increases, it would encourage dealers to charge more for their vehicles to maintain a profit.
Demand-pull inflation: This occurs when demand increases so much that suppliers can afford to charge higher prices because consumers are willing to pay them. For example, if everyone suddenly desperately wanted toilet paper for some reason, the cost of a roll may rise.
Built-in inflation: Think of this as inflation momentum. When consumers expect inflation, they demand higher wages. In turn, that increases the costs of production for their services, which creates more inflation. The process leads to a kind of feedback loop.
These are the natural causes of inflation in most economies. Even if left mostly ungoverned, prices will tend to rise over time thanks to these three phenomena.
What causes hyperinflation?
While shifts in supply and demand are the primary natural causes of inflation, government influence also plays a significant role. Remember, the Fed is responsible for keeping inflation at reasonable levels.
One of their tools for doing so is manipulating the money supply. One popular economic theory proposes that decreasing the cash in circulation will discourage spending and limit inflation.
Conversely, increasing the money supply would stimulate spending and increase inflation. That tactic, when taken to the extreme, is what typically causes hyperinflation, especially when combined with demand-pull inflation.
For example, the central bank of an economy might increase the money supply too much, causing prices to rise.
As a result, consumers buy up goods in excess before prices increase even higher. The increased demand drives inflation up further and the two continue to exacerbate each other.
Consider taking steps to hedge against inflation
While we’re not currently experiencing hyperinflation (it’s pretty rare), even slightly elevated levels of inflation can create problems for consumers. Inflation was 5.4% in the 12 months ended June 2021, which is the highest it’s been in years.
There are steps you can take to protect yourself against rising inflation. Some good strategies might be holding onto less cash and investing in assets that hedge against inflation.
Inflation may erode the value of your debts, but that doesn’t mean you need to let them linger longer.
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