Rounding it up
Inflation is the continual decrease in the value of a currency
Inflation is a net positive when it is moderate because it spurs wage growth and investment.
High inflation is unsustainable and causes investors to hold onto money as opposed to spending.
Low inflation, or worse, deflation, is disastrous for an economy because products are no longer profitable to produce.
Inflation is one of those words that you hear on the radio or read in the news all the time and know that you should feel something about it, but perhaps don’t know exactly what. It doesn’t sound great but sometimes it seems like the government likes it? But not too much of it? If you’re confused, you’re not alone.
Inflation is an organic economic phenomenon that a healthy government or central bank can control, to a certain extent. When it’s a small amount, inflation can be a sign of a strong economy. But what does it actually mean for you? Let’s look at what inflation is and a few of the pros and cons that are important to understand.
What is inflation?
It’s got nothing to do with a tire or a small backyard pool of any kind. Inflation, put simply, is a decrease in purchasing power of a specific unit of currency over a set period of time. In practice, this means that $1 buys less today than it did just a few years ago. This is why your grandparents remember buying a Coca-Cola for a dime or similar and that same bottle of coke costs upwards of $2 today.]
Inflation occurs because the value of a dollar increases, but why does this occur? There is more money—literally more currency—in the economy than there was previously and thus the value of any one piece goes down. Governments want this to happen at crucial times for their citizens. For example, during the pandemic, many governments developed aid packages, tax deferments, and stimulus payments to help consumers. Because there is more money available, companies will often make products more expensive.
“That’s not great…” you may be saying. Well, it’s not the greatest, but the alternative is having a group of people with less money available than that on which they can live. And that’s not ideal at all. A slow and steady increase in inflation is actually considered a net positive. This is because it shows that consumers and businesses have money and are spending it.
What causes inflation?
A natural ebb and flow in supply and demand accounts for the slight increase in inflation. There are three “regular” reasons for inflation.
First is the demand-pull effect that occurs when an increase in cash or credit and demand occurs faster than the country’s economic output can withstand. This effect is the one we have seen every day since the pandemic began. Suddenly, the demand for toilet paper, home gym equipment, and bleach ballooned and thus, the price of each went up because availability went way down. Folks were willing to pay a bit more for each, in many cases.
The second is the cost-push effect that occurs when the prices of intermediate commodities, or things that go into finished products, become more expensive or are less available, causing the price to increase.
The final cause of inflation is purely mental. Because people see some products becoming more expensive, they will demand higher pay, which will cause products to become more expensive, and so forth. This phenomenon is called a wage spiral.
Central banks can influence these factors by controlling the flow of money and either increasing the money supply or reducing it. They don’t do this by going to banks and taking money but instead, increase or decrease the interest rate at which they lend to banks. At high rates, banks will borrow less, which will reduce the supply. At low rates, which is what we’re experiencing now, banks will borrow more and lend that money out to people in return.
Inflation and the average person
Ok, so inflation is kind of good, and kind of bad? Right. But what does this mean for you? Well, all in all, moderate inflation is good in the aggregate even if it doesn’t seem so for you at a specific moment. Here’s why:
Economic growth: Moderate inflation is a sign of economic growth and sustained moderate, stable inflation can prolong that growth. This is because prices and wages naturally increase in tandem, allowing consumers to continue borrowing and purchasing while allowing businesses to make more money.
Wage adjustment: When the cost of goods goes up, consumers need to have more money to purchase them. When this happens they tend to push their employers for higher wages. In order to remain competitive, employers have to continually offer higher wages. This has an added benefit for businesses as well; they have a built-in incentive to only hire productive workers since they’re paying a higher wage. This allows businesses to trim those who are underperforming and replace them with better employees. For the average worker, jobs pay more and are more plentiful.
Product adjustment: Businesses are able to price their products more effectively when demand is higher. Better sales mean better and more plentiful jobs for consumers. This becomes a positive cycle which means that you tend to get a better deal for products you want.
Deflation is hurtful: Perhaps the most powerful argument in favour of inflation is that the alternative is disastrous. Deflation occurs when the value of a currency falls. The price of products follows suit because consumers won’t be able to purchase at higher prices. This can continue until it is no longer profitable to actually create products. In addition, when consumers see prices headed down, they are less likely to purchase or invest, hoping for cheaper prices down the road. Deflation was a major factor during the Great Depression in the 1920s and 30s.
But what about the Cons of inflation?
It’s not all good news. There are some cons to inflation that can affect your bottom line. These mostly apply to higher than normal inflation because a moderate amount is nearly always a positive (for the above reasons).
It’s not sustainable: Higher inflation, while it may create a booming market for a moment, is not necessarily sustainable. This is because it leads to unpredictable boom and bust cycles. The economy will be chugging along great for a bit, but then prices or wages will hit a wall and things will become unaffordable quickly.
Uncompetitive: If inflation is high, that means the cost of products tends to be higher. This can make a country very uncompetitive with others around the world. Products may sell around the world for X, but due to inflation, a country can only sell that product for X*2.
Discouraged investment: High inflation is unpredictable, which leads to less investment. Because prices and values are rising so quickly, investors tend to think that they won’t be that way forever and choose instead to hold onto cash in a savings account or keep it in safer investments. This also reduces investment in machinery and other things that are used to create products.
What does all this mean for me?
A moderate amount of inflation is a good thing for the economy. With a moderate amount of inflation, wages tend to increase, and although product prices increase as well, the two move in tandem allowing consumers to continue purchasing. Moderate inflation also allows for stable and appropriate wage increases, meaning that consumers have more money to invest and spend. High inflation is bad for you because it can lead to an unsustainable and wild economic environment where the cost of products outpaces your paycheck. Low inflation means an economy is stagnating and paychecks may fall, making it harder for you to spend. As with all things, moderation is key.
Dan is a runner and writer living in the Washington, D.C. area, where he currently works for a financial services trade association as the Communications Director.