Have you ever talked to your parents or grandparents about what prices used to be when they were
kids?
If so, they probably told you about how milk and candy and hot dogs used to be much cheaper,
and it’s true.
Over long periods of time, most things do tend to get more and more expensive.
This is due to something called inflation.
Let’s look at an example.
Jane and Bob bought their house in 1970 for $15,000 and have lived in it ever since.
However, now that they are finally looking to retire and downsize, they find that their
home is now worth $150,000.
The reason for this isn’t just supply and demand.
It’s inflation.
Inflation is simply a general increase in prices and fall in the purchasing value of
money.
We’re not talking about the prices of specific items here.
We’re talking about prices going up for almost every commonly purchased item.
When inflation is rapid and dramatic, that is generally unsustainable and leads to an
economic crisis.
Such an event is called hyperinflation.
Essentially, hyperinflation is inflation that’s going out of control.
One negative consequence of inflation is a drop in purchasing power.
Purchasing power is the amount of stuff you can purchase with a unit of currency.
As prices go up, the purchasing power of money goes down.
If you were hoping to follow the lead of Jane and Bob, try buying a house today for $15,000.
It’s quite unlikely that you’ll be able to find anything at that price point.
So how do we know that prices are going up across the board?
Well, thankfully economists have come up with things called price indexes, which are measurements
that show how the average price of a standard group of goods changes over time.
In the United States, the best known of these is the Consumer Price Index, or CPI.
The CPI is determined by measuring the price of a standard group of goods and services
meant to represent a “market basket” of stuff typically bought by your average urban
consumer.
Here are the eight categories of goods and services that CPI currently looks at, with
examples of each listed.
Keep in mind that every 10 years these categories are updated to adjust for changes in spending
habits.
American economists use the CPI to calculate the inflation rate, which is the percentage
rate of change in price level over time.
Although they can calculate this between any two points in time, typically it is done from
one year to the next.
Generally, we want at least a little bit of inflation.
In fact, an inflation rate of around 2-3% is considered a good thing in order to promote
investment and economic growth.
People are more likely to invest capital if they know that prices are likely to go up
from year to year.
So what causes inflation?
Well, economists debate about which cause is the most significant, but they generally
agree on three main causes.
First, the quantity theory of inflation states that too much currency available can cause
prices to go up and purchasing power to go down.
This makes sense if you think about it.
If a government just creates money out of thin air, there is a certain point where it
won’t be worth anything anymore.
We’ve seen this precise thing happen quite recently in places like Bolivia, Venezuela,
and Zimbabwe.
In fact, at one point Zimbabwe’s hyperinflation was so bad due to over printing of their currency
that at its worst between 2007 and 2008, its inflation rate was 89.7 sextillion percent.
If you’re wondering how big that number is, this is what it looks like: 89,700,000,000,000,000,000,000%.
The second cause of inflation is an increase in aggregate demand, or the total demand for
all finished goods and services in an economy.
This usually happens due to higher income.
If more and more people can afford to buy stuff, they will, and the result is an increase
in prices across the board.
The third cause of inflation is when producers have to spend more money in order to produce.
For example, if producers have to pay their workers higher wages, they might raise their
prices to adjust for a potential loss in profit.
Inflation is most concerning for those on a fixed income, or an income that does not
increase even when prices consistently go up.
One example of this is those who get government assistance, such as Social Security payments.
Governments can be slow to adjust payments to keep up with inflation.
The opposite of inflation is deflation, which is a reduction of the overall level of prices
in an economy.
Economists generally view deflation as a negative thing since producers respond to falling prices
by slowing down their production, which leads to layoffs and salary reductions, ultimately
causing the economy to stop growing.
So that covers the concept of inflation and deflation, as well as their causes.
We must understand that inflation is more or less inevitable.
We cannot escape rising prices.
And in fact, we do want at least some inflation, because as long as we are able to adapt to
it, it’s better for the economy in the long run.
So let’s move forward and learn about some other concepts in economics.