An illustration visualizing inflation and how it causes grocery prices to climb.
Inflation is when goods and services rise in price, making money worth less. The more it rises, the less your money can buy, so what costs $12 today might have only cost $6 a few years ago. Inflation is felt by everyone, whether it be consumers or businesses. While some inflation is normal, it can create a lot of problems if it gets out of control. In this article, we will go over how it works, why it happens, and how it impacts both the economy and your life.
What Is Inflation?
Inflation is basically the increase in overall prices in a given time period. The Consumer Price Index (CPI) measures inflation by tracking the cost of food, transportation, and housing. For example, when the CPI goes up by 3%, it means that the average price of goods and services has risen by 3%. Economic growth leads to inflation, and most central banks, like the Federal Reserve, aim for a small yearly inflation rate, typically between 2% and 3%.
You'll find inflation in every economy, but too much can cause problems because inflation reduces the buying power of money. This hurts everyone, especially those on fixed incomes (eg. retirees), because their money doesn't stretch as far as it used to.
What Causes Inflation?
Sometimes, inflation is caused when demand exceeding supply, and this is called demand-pull inflation. Take a popular tech gadget as an example. When everyone wants to buy it, the company might raise its price just because people want more than what the company can physically produce.
Another thing that causes inflation is when it just costs more to make stuff. We call this cost-push inflation. If raw materials, like oil, get pricier, businesses might bump up their prices to cover for those higher input costs.
Inflation can happen when there's too much money floating around in the market as well. As the central bank prints more and more cash, money becomes less and less valuable. If there's more money out there but the same amount of stuff to buy, prices will climb. This type of inflation is called monetary inflation.
How Inflation Affects the Economy
Inflation can be good or bad depending on its rate and is often seen in a positive light when at a moderate level because it indicates an economy's growth. With slight inflation, spending and hence investment are encouraged, permitting the growth of businesses. When businesses grow, they employ more people, and larger spending and investment schemes take shape.
However, high inflation creates problems. If prices rise too quickly, people can no longer afford their necessities with ease. Also, while rising costs eat into profits and present uncertainty to business, unpredictable inflation can cause delayed investments, thus stunting economic growth. A lot of the times, uncontrolled inflation can quickly turn into hyperinflation, where prices spiral completely out of control and money becomes almost worthless.
Inflation and Interest Rates
Inflation is closely interconnected with interest rates. The ability of the central banks to control inflation arises mostly through the channels of interest rates. If inflation gets too high, interest rates might be tightened to increase the cost of borrowing. Once borrowing becomes more expensive, people and businesses tend to consume less, which can help decelerate inflation. Raising interest rates can, however, dampen the economy and increase unemployment; therefore, central banks have to make changes wisely. Lowering interest rates, on the other hand, will decrease unemployment but increase inflation drastically.
Why Inflation Should Matter to You
Inflation is important because it plays a major role in the quality of life. If prices increase faster than your income, you won’t be able to maintain your standard of living. For example, the effects of inflation can be seen when the price of food increases by 5% but your earnings remain constant; more of your money will be eaten up by basic necessities, and you will have less money left over for buying miscellaneous items. In addition, inflation can creep up on your savings. Suppose that you have deposited $1,000 into a savings account at 4% annual interest. At an inflation rate of 5%, that money, over time, will gradually lose its original value. As it can be seen, even though there is interest collected on that money, the amount isn’t enough to cover for the inflation. Inflation, however, does benefit borrowers, since the amount they have to pay back, in terms of buying power, is worth less than what it was worth when they first borrowed it.