If someone asks you ‘how much is a $50 bill worth?’, your answer would probably be ‘fifty dollars’. The reality though, is that money does not have a fixed value. It is part of a system that goes beyond the physical cash we use to pay for things every day. Instead, the value of your money is changing all the time, depending on a number of things. Sometimes the fluctuations are good and work in your favor (the value of your money goes up), and other times, they’re bad and negatively impact how and what you can purchase (the value of your money goes down).
Inflation is the term used to describe when the purchasing power of a currency (essentially, its value) falls and the general cost of things increases. Every nation experiences natural inflation, and according to the Federal Reserve, a healthy inflation rate is around 2 percent per year.
To really get to grips with inflation, here’s what you need to know:
What is inflation?
Put simply, inflation is the increase in prices or goods over a period of time. Say your weekly grocery shop in 2010 cost you $100. Today, however, that same shop costs you $110, so you have to remove one or two items to be able to afford it still. This means that the purchasing power of your money has gone down – you can’t buy as many goods with the same amount of cash.
Inflation is most commonly measured via the Consumer Price Index (CPI) or the Personal Consumption Expenditure Price Index (PCE) which calculate the percentage change in the price of goods and services consumed by people across the U.S.
Although inflation can happen organically, it poses certain risks to a nation’s economy if it’s not controlled. It can have a domino effect whereby the cost of living increases and domestic economic growth slows.
What are the types of inflation that exist?
There are two types of inflation: ‘cost-push’ and ‘demand-pull’. Cost-push inflation is when prices rise because the cost of materials and products has risen. It is normally a short-term form of inflation, however, some experts argue that it ultimately leads to long-term inflation.
On the other hand, demand-pull inflation is when demand for goods is bigger than the supply available. To ensure profits are made, the price of goods is upped. For this type of inflation, a nation’s money supply grows faster than the nation’s economy. If more dollars are issued, then the value of each dollar goes down.
Think of it like this:
More money printed ➡️ people have more cash to spend on the same amount of goods ➡️ the same number of goods are available ➡️ demand outweighs supply ➡️ prices go up.
What causes inflation?
There is no one source that causes inflation; it’s typically a combination of events and decisions made by governments, banks, and corporations. For example, unemployment, changing interest rates, increasing lending, and housing prices all play a role in inflation.
That said, central banks are responsible for monitoring and alleviating inflation. In the U.S., the Federal Reserve adjusts its monetary policy to prevent prices from rising too quickly. While central banks react to inflation, they are part of a wider network that actually contributes to it.
Central banks, which are responsible for monetary policy and producing money, are the banks that commercial banks use. Central banks regulate smaller banks, oversee lending, and decide how much cash they should keep. In commercial banks, a process called fractional reserve banking means that only a small portion of money deposited by people is actually kept in the bank. The rest of the money is used to generate loans with higher interest rates and thus creates money out of thin air – increasing the money supply and initiating the inflation cycle.
So, while fractional reserve banking is profitable for banks, a by-product is that it stimulates inflation.
What’s an example of inflation?
The United States Department of Labor, Bureau of Statistics states that in January of 1988, a loaf of white bread cost approximately 59 cents. By January 2013, the exact same item cost $1.42 – a 140 percent price increase over 25 years. Of course, it’s important to remember that inflation is determined by more than one single item. The annual inflation rate from 1988 to 2013 was 2.79 percent, and $10 in 1988 was the equivalent to $19.90 in 2013.
More recently, in the COVID-19 crisis, the Federal Reserve has been printing money to cope with the sudden drop in economic activity. By the end of 2020, predictions state that the Fed will have created equal to $3.5 trillion. Although the money is intended to get markets back up and functioning, there is a danger that it’s not a sustainable solution. Critics say there will be too much money chasing too few goods, and prices will rise while the dollar drops.
The consequences are yet to be fully felt, but the risk of inflation in already unstable conditions brings to light the need for reexamining the way our current financial system works.