Inflation, explained
Money printer go brrrrr
In 1920, a new Chevrolet car would set you back $525 USD. Today, Chevrolet is selling their Chevrolet Spark for nearly $17,000. And this massive increase in price isn’t just for cars either. Nearly everything from food to housing has become more expensive within the last century. How could this be? We have greater production capacities than ever before, creating crises of abundance rather than shortage. As such, the cost of things should actually be going down, no?
Inflation, the general rise in prices, is the primary culprit here.
What causes inflation?
Demand-pull inflation
This is the most common one - it’s when the demand for a good or service outpaces the supply for said good or service. Buyers want something so much that they’re willing to pay more for it.
Cost-push inflation
A less common source, but it’s when the supply of a good or service becomes restricted. Demand doesn’t even have to change for the price to rise. For example, if a disaster damages the supply lines for gasoline, there’s going to be less gasoline available. As a result, the cost for gasoline will increase. This is what happened with Hurricane Katrina - people didn’t suddenly want more gasoline, but the price went up to $5 per gallon.
Monetary policy
This is the one economists concern themselves the most with since it’s the only factor people have control over. Monetary policy is the policy that controls the country’s money supply. An increase in the money supply means more inflation. Refer back to the gasoline example - the decrease in the supply for gasoline caused the price to increase. So by contrast, increasing the supply for gasoline must decrease the price. Generally speaking, the more there is of something the less it’s worth.
Currency isn’t exempt from these principles. If there are only 10 coins in circulation, you’d be able to buy quite a lot with just one coin, enough to buy a house let’s say. But if there’s 100 coins in circulation, one coin isn’t worth as much anymore. You’d need 10 coins to buy the house. Did you see what just happened? The price of the house went from one coin to 10 coins.
Why do we have inflation?
Why must our dollars lose their value over time? Wouldn’t an economy without inflation make us all better off? One standard explanation is that if prices stop rising, consumers will hold back on spending in hopes of getting a better deal. Let’s say you’re buying an appliance for $1000 but you then all of a sudden realize that because prices are falling 0.5% per year, you can save some money if you wait long enough.
Without the inflation that incentivizes people to buy, aggregate demand (the total demand for finished goods and services in an economy) is lowered. But the effects don’t stop there. When consumers don’t spend, companies make less money, meaning workers’ wages are going to decrease. We can also think of inflation as a safeguard against recessions. The standard practice for fighting recessions, which are characterized by lowered aggregate demand, layoffs, etc, is for the central bank to lower interest rates for loans, encouraging consumers and businesses to invest and spend. Lowering interest rates requires some inflation; by increasing the supply of money, the cost of borrowing is lowered.
If the inflation rate is 0%, the central bank doesn’t have any room to lower interest rates and thus little of any opportunity to jumpstart the economy.
Hyperinflation
In the case of the German Weimar Republic, for example, inflation got a little out of hand. As part of the Treaty of Versailles, Germany had to pay the victors of WW1 a huge amount of money it didn’t have, so they attempted to print paper notes, buy foreign currency with them, and use that to pay their debts.
This policy led to the rapid devaluation of the German currency, causing hyperinflation. This is a term to describe rapid, excessive, and out-of-control general price increases. Hyperinflation is one of the most destructive and tragic events that can befall a nation. People lose their jobs and businesses close down. If the period of hyperinflation is long enough, essential items like food start to become more scarce. Society itself begins to crumble. Thankfully, hyperinflation is not a common occurrence in developed nations or even throughout history.
And it’s precisely this reason as to why monetary policy and controlling inflation is so important - it really can either make or break an economy.