Inflation is a word that gets thrown around a lot in both the media and political speech: 'inflation has destroyed the economy,' 'inflation is enemy number one', 'if so-and-so is elected, inflation will never be so high again.' But what is inflation, really? It seems important to know if we want to understand the economy or business. And thankfully, as far as economic terms go, it's not all that complicated.
The short answer is that inflation is an increase in the general price of goods from one year to the next. The cost of living, as represented by the price of everyday goods, just inflates by a certain percentage. The more complex answer is that inflation is the erosion of the value of money over time, meaning today’s dollar won't get you as much as it would in the past.
To help makes sense of those answers, the following article will explain how inflation is measured, some of the most frequent and basic ways inflation happens, and finally the good, the bad, and the ugly of it when it does happen. Given the complexity of the issue, we have simplified the concepts quite a bit, but the essentials are here. By the end of this read, readers will be able to be outraged at the heinous rates of inflation with the best of them, or maybe even be able to tell the best of them to calm down and embrace a bit of inflation.
How We Measure Inflation – The CPI
The thing most people want to know is how this increase in the price of goods is measured. How do we know that prices are up by a certain percent and that our money is won't stretch as far? The answer to this lies in the consumer price index (CPI), but more specifically and more usually, the urban CPI. Why the urban CPI? Because no offense to rural consumers, but that's just where most people live, and that's where most money is spent.
The CPI is determined when a bunch of economist get together and create a hypothetical basket of goods which is meant to represent the basic needs and purchases of the average consumer. This basket contains average prices for basic foods, utilities, entertainments, and so on. They then measure the CPI from year to year and determine how much more or how much less that basket costs. Great increases indicate greater inflation. So what this means is that the difference between the 1910 and the 2010 baskets reflect the extent of inflation from 1910 to 2010.
Inflation From Too Much Stuff
One of the most common ways for inflation to occur is for there to be a massive decrease in the number of goods, which in turn sends prices skyrocketing. This usually occurs from a supply shock, like a natural disaster, war, or crazy, irresponsible business speculation. By itself, this situation doesn't sound too terrible. If you don't want to buy the overpriced car, what's the worst that could happen?
This simple, fiscally responsible act, however, when multiplied by consumers across the economy means the car manufacturer loses profits, and will likely lead to the owners firing employees and closing factories. This in turn means people can't buy other stuff, so inflation spreads into other markets, and then eventually into other countries, until suddenly you have a global crisis where no one can buy anything.
Inflation From Too Much Money
Another common way inflation comes about and creates a negative loop is in poor financial management. Because money isn't really tied to any one thing as a standard measurement, the value of any dollar is determined by how many dollars are in circulation and how much each of them can buy. Like any commodity, if there is a lot of money in the system, its value drops. What this means is that if governments mints too much coin, that money starts to lose its meaning, and the prices of goods must go up to make sense of it all.
A good analogy is of a friend who writes the same I-owe-you every time he borrows a dollar. Being irresponsible, this person never pays these IOUs back. Naturally, you and your friends begin to refuse the clearly bunk notes. To get you to accept his IOUs in return for one dollar, he begins to offer more than a dollar per IOU.
Eventually, however, he owes so many IOUs at such ridiculous amounts that they are viewed as completely worthless. His only solution is to stop writing the IOUs and pay some people back, or continue to write such ridiculous amounts on the notes that people just quit dealing with him altogether. Essentially, this is what happens when governments print far too much money. The price of a good goes up because the money lost its intrinsic value, and the money lost its value because there was just so much of it.
The Good Inflation
Contrary to what many people may think from the language used in the media, moderate inflation is actually a sign of a fairly healthy economy. While extreme inflation of either kind already discussed is clearly bad, a little bit of inflation now and then can be good.
Simply put, more employment means more purchasing power, and that means producers are selling more goods. This inspires these producers to take a positive view of the future, and inspires them to increase prices slightly to make more profits, and voila: inflation. Of course, higher prices do lead to less buying, but the profits that lead to higher prices also lead to more production, greater supply, and then lower prices and higher wages. This is an oversimplification, but the point is that moderate inflation is indicative of a healthy, growing economy.
The Bad Inflation
While some inflation means people are making money and spending it in true capitalist fashion, a lot of it means we're doing something wrong either on the supply side or the money side. The most feared economic situation with inflation is stagflation, a portmanteau of stagnant economy and inflation. This is what happens when prices go crazy high, but the economy has no way of reacting to it through reduced spending, more efficient production, alternative markets, and so on. Basically, people can't afford to buy stuff, so prices go up.
And The Ugly Inflation
There is such a thing as negative inflation, and since some inflation is good, deflation isn't necessarily great. Deflation occurs when the price for buying the basket of goods determined in the CPI is less than the year before. While this may initially seem like a good thing for consumers, deflation is typically less desirable from an economic point of view.
First, it's harder to control deflation through printing money and interest rates because these more often than not exacerbate the difference, and on a consumer level, it causes frustration and a loss of faith in the economy. We can all relate to the experience of buying a laptop for $1500, only to see a better model for $1000 the next year. Negative inflation is like that, but for everything.