If you’ve been paying attention to the news recently you might have heard a little word called inflation. Inflation is essentially the devaluing of a currency. While many people have a connotation that inflation is very bad, inflation on its own is actually a necessary part of a functioning economy.
Inflation is the reason things seem to get more expensive over time, both because goods get more expensive and a dollar goes less far to purchase things. Generally inflation is expected as a percentage decline in value, and generally the Federal Reserve in the US targets inflation to be at roughly 2% per year, but a variety of factors cause inflation to swing up and down.
Defined simply, inflation is the rate at which a value of a currency falls and the price of goods rises. People who own goods or assets, generally like inflation because these goods go up in value, but people holding cash don’t like inflation because it decreases cash’s value.
What is Inflation Caused by
Inflation is caused primarily by an increase in the supply of money. If a good has one value with one total supply of money, in order for the ratio of value to the total money supply to stay the same, or how generally expensive or cheap something is, when the overall supply of money goes up, so too does the value of that good.
Some inflation is caused by a demand-pull effect, or an increase in demand for goods, usually from more money, without an increase in supply. When there’s more demand but the same or decreasing supply, the price has to go up!
There’s also the Cost-push effect, which is when the production of goods increases or becomes cheaper while the overall demand stays the same. If you have to sell more goods to the same people, the price has to lower so they want to buy them. For example, when there’s a boom in oil production, gas prices conversely will lower.
Finally, there’s also built-in inflation, which occurs when a population expects inflation, demanding more pay for the same work, resulting in people having more money, resulting in prices of goods going up, resulting in more inflation. This final step can spiral out of control without a centralized approach to handle it.
Inflation is often viewed as good because it promotes investment. When you expect your money to be less valuable in the future, you get out and spend it now on investments that will grow to counteract that value decrease.
Who does inflation hurt
However, inflation does generally hurt people without assets and low amounts of cash to invest. If these groups of people don’t see wage increases, then over time the same salary numerically actually becomes worth less and less. This is why countries raise minimum wages and why companies will often process annual raises.
The last thing to realize about inflation is that it can generally be controlled by adjusting financial levers at the central banks of a country. By adjusting interest rates, the central bank can temper or accelerate interest in investment, by association influencing inflation. Inflation can get out of control though when consumer sentiment and outside factors fly off the handle. In these situations, we see hyperinflation where a currency is rapidly devalued and economies can collapse if this occurs. But for the most part, inflation is a carefully controlled metric and to be expected in modern economies.