Inflation destroys wealth.
When inflation happens, the amount of things you can buy with your money decreases. But why does this happen? What is inflation? Is it necessary for a functioning economy?
Let’s find out!
What is Inflation?
At its core, Inflation is a measure of the average price increase for a basket of goods that include key items that everyone needs. This basket of goods typically have things such as:
- And many more everyday goods/services….
If the rate of inflation in America is 2%, then every year we will be able to buy 2% less goods and services with the same amount of money.
If your income doesn’t keep up with the pace of inflation, then your purchasing power goes down.
A good example would be the cost for a bag of chips from a vending machine. The bag of chips used to cost $0.50, then $0.75 a few years later, then $1.00 a few years after that, and the prices keep going up.
If you had a dollar back when the bag of chips cost $0.50 then you could get two bags for your dollar, but now you can maybe get a single bag of chips for your dollar. The purchasing power of your dollar has decreased.
So how and why do prices for goods rise? The rise in cost usually comes as a result of businesses raising their prices. If times are slow and they are having trouble selling their goods, then prices will drop. However, if times are good and things are flying off the shelves then prices will inevitably go up.
One thing to note is that an increase in price due to inflation is not the same as an increase in price due to quality. For example, if a Model XYZ computer costs $1000 last year but costs $1100 this year, the price rise isn’t purely due to inflation. There is likely an increase in quality for the product due to better processors, memory, screen and so on.
There is also a strong psychological factor to inflation. It’s not some formulaic, mechanical process that occurs predictably. After all, there is usually a human element involved when a business raises their prices.
You might have also heard the term “deflation”. Deflation is the exact opposite of inflation, and occurs when there is a drop in the average price for the same basket of goods.
What Causes Inflation and Deflation
Inflation happens when too many people have too much money and they’re all trying to buy the same goods and services. For example, if everyone suddenly got an extra $50,000 then we would likely be out buying things with that money – and businesses would probably raise their prices.
When there is too much money flying around then the prices of everything starts to increase and this is what causes inflation.
Deflation usually happens when businesses don’t produce as much since they don’t feel that there is demand for it. Some businesses will drop prices in order to capture whatever demand there is left.
Deflation has a strong psychological effect on customers. If you see prices dropping all the time, then maybe you’ll hold off on buying things because you think the prices will continue to drop.
Uncontrolled deflation is just as dangerous as uncontrolled inflation.
What is Hyperinflation
Hyperinflation is inflation gone wild. It’s technically defined as an inflation rate that is higher than 50% per month.
How crazy is that? 50% per month! This means that something like a box of cereal could cost $5 at the beginning of the month, and that same box would cost $7.50 at the end of the month. Or that $20,000 car at the beginning of the month now costs $30,000 at the end of the month.
Once the cycle of hyperinflation starts it is hard to stop as people will want to spend their money as soon as they get paid. This would likely cause businesses to raise their prices even more and reinforce the hyperinflation cycle.
As insane as this all sounds, hyperinflation does happen. In 2018, Venezuela had an inflation rate of 1,700,000% – and no that’s not a typo. In the picture below you can see money just laying on the streets of Venezuela since it was worth basically nothing.
This particular case of hyperinflation came as a result of the Venezuelan government increasing the money supply by more than 10%, and people losing faith in the integrity of their central bank. The situation got so bad that people were using cartons of eggs as currency. America hasn’t had anything close to hyperinflation since the Civil War when the Confederates printed money to pay for war expenses.
To have hyperinflation these days you essentially need a failed government..
How Central Banks Try to Control Inflation and Deflation
Central banks aim to control inflation and deflation to keep their economies functioning effectively.
To combat inflation, you have to make people and businesses less willing to borrow money to buy stuff. Central banks to this by raising the interest rate. Whenever you hear the Federal Reserve saying they are raising their benchmark interest rate, they are trying to keep inflation in check.
If it’s more expensive to borrow money, then the amount that people borrow will be less. If less people and businesses are borrowing, then in essence less money is being created (check out our article on “What is Money” if this doesn’t make sense). You now have less money chasing the same amount of goods and services, and this drives prices down.
To combat deflation, the central banks do the opposite. They will drop interest rates in the hopes that this will make people and businesses more willing to spend money. However, this may not be enough because people and businesses may not borrow money even if it’s easy to do so.
If people and businesses don’t want to spend money, then the federal government is essentially forced to spend money themselves and run a deficit to inject money into the economy. When you see the economy struggling and the federal government starting a bunch of infrastructure projects, this is what they’re trying to do.
Deflation is very hard to stop once it gets started. This is the reason why most central banks are willing to run a slight inflation 1.5%-3% just to make sure they don’t get themselves into a deflationary environment.
Why is deflation so dangerous? One of the main reason is that almost everyone takes out loans to buy things.
Let’s consider a house that was purchased for $100,000 where the buyer took out an $80,000 mortgage. In a deflationary environment the prices of things drop. This means that the $100,000 may now be worth only $60,000. However, the buyer still owes the bank $80,000 on the loan. This situation would force a lot of people to be underwater, and can potentially collapse the economy as no one would want to buy anything.
In a deflationary environment, as soon as you buy something it is worth less than what you paid for it so people are inclined to hold on to their cash. Without consumer spending our entire economy would grind to a halt.