What is inflation?
Inflation is the rate at which prices for goods and services rise over time. For example, if you find that you are paying more and more every month for the same amount of groceries, that would be an example of food price inflation. What is actually happening is that the purchasing power of money is declining. Because the stated value of money stays constant – a $20 dollar bill is always a $20 bill – inflation manifests itself as higher prices.
What causes inflation?
As noted above, inflation is a decline in the purchasing power of money. This is often caused by governments that are overspending – running large yearly deficits and adding to the debt – and who thus seek to borrow more and more money. Central banks will often ‘print’ that money (nowadays it is simply generated on a computer). As that money floods into the system, there is a larger supply of money. While that may sound good in theory, that larger supply of money doesn’t mean there are more goods and services. As a result, there is more money chasing the same amount of goods and services, making each individual unit of money less valuable.
Inflation can also be caused by product shortages – due to either lower production or higher demand. For example, if supply chains are heavily disrupted, there will be fewer goods. Thus – as with an increase in the money supply described above – there will be more money chasing fewer goods, thus leading to higher prices. Likewise, if individuals are becoming more productive and wealthier, demand for goods and services will increase. This will lead to higher prices.
Inflation can also be caused by higher production costs. For example, if a government introduces a new tax that impacts businesses and raises the cost of production, those businesses will have to raise their prices to compensate for the money being taken by the government. This will result in higher prices.
Types of inflation
Demand-pull inflation
As noted above, when prices rise because of increased demand for goods and services, this is called demand-pull inflation. This can happen for positive or negative reasons. For example, if a new innovation leads to rapidly increasing living standards and wealth, demand for goods and services will surge. That would be positive. On the negative side, if a government borrows vast sums of money – thus increasing the debt – in order to distribute that money before and election, there will be a short-term increase in demand and prices will go up. But that short-term increase will have long-term negative consequences.
Cost-push inflation
When the cost to produce goods or deliver services goes up, prices will go up to compensate. This is known as cost-push inflation.
Most businesses have relatively low profit margins, meaning the only way they can afford higher input costs is to pass those costs on to consumers. For example, if the government increases the minimum wage, many businesses will have to increase prices to make up the difference. This is why the government can’t make everyone rich by decreeing a million dollar per-person minimum wage. If they did so, business would have to increase prices immensely. People would perhaps have millions of dollars in their bank accounts, but a loaf of bread might cost tens of thousands of dollars, so people wouldn’t actually be better off than before.
Cost-push inflation can also occur due to supply disruptions. For example, a war can disrupt the supply of energy or raw materials, increasing input costs for businesses and driving up prices.
Hyperinflation
Rather than restrain spending and balance the budget, many governments seek to borrow more and more money. If the economy grows at a rate equal to or higher than the rate of borrowing, this can be somewhat manageable.
But when borrowing vastly exceeds economic growth, and when government’s seek to print money to deal with rising debt, hyperinflation can occur. Hyperinflation is inflation taken to an extreme. A government floods the economy with so much money that money begins to lose any sense of value. This wipes out people’s savings and destroys confidence in the currency. And without confidence in the currency, the whole economy begins to break down.
Wage-price spiral
A wage-price spiral is when wages go up to due to rising prices, but those rising wages then cause companies to raise their prices, which then cause demands for higher wages, and on and on. This is usually a manageable issue when the market is left alone and is free – or at least mostly-free – from government interference.
Stagflation
It was once believed that rising inflation would always go hand in hand with low unemployment and a strong economy. This belief was shattered by the phenomenon of ‘stagflation,’ when many economies around the world simultaneously experienced high levels of inflation, high unemployment, and weak economic growth. Often, stagflation must be countered by pro-business measures that free entrepreneurial individuals to innovate and create jobs, along with restrained government spending and restrictions on the growth of the money supply.
Asset price inflation
When the prices of things like real estate, stocks, and bonds increase over a sustained period of time, this is asset price inflation. During speculative manias for example, people will pour money into an asset with the expectation that it will keep going up. This draws in more and more money, pushing the price up further. At some point, the price of the asset is no longer connected to a fundamental value, it is simply going up based on people speculating that it will keep rising. This often ends in a rapid decline in the price of the asset when the speculative exuberance wears off.
Inflation calculator
To find out how the purchasing power of your money has declined over time, you can use an inflation calculator. Below, you will find links to both U.S. & Canadian inflation calculators:
U.S. Dollars Inflation Calculator
Canadian Dollars Inflation Calculator
Consumer Price Index (CPI)
When we discuss inflation, we are often talking about the Consumer Price Index (CPI). The CPI is a fixed basket of goods and services that are tracked over time to note the changes in price.
Food, healthcare, transportation, housing, clothing, energy, education, and other goods & services are included in the basket of goods.
The prices of goods & services in the basket are weighted based on their overall importance. Out of that weighting comes a single number, the CPI. Changes in that number represent the rate of inflation, or deflation if prices go down.
Some criticize the CPI, as governments can subtly change the items tracked in the basket of goods to make the rate of inflation appear smaller. For example, a medium quality type of food can be replaced with a cheaper, lower quality type of food. This could make food price inflation look more stable than it is, by hiding a large increase in the medium quality item which is now excluded from the basket.
Additionally, government’s often tie payments to seniors and other fixed-income groups to the rate of inflation, creating an incentive for government’s to have the inflation rate appear lower than it really is.
Producer Price Index (PPI)
While most news reports and political discussions about inflation focus on the CPI, the Producer Price Index (PPI) is also quite important.
The PPI measures changes in prices received by domestic producers for their output of their products over time.
Similar to the CPI, the PPI tracks a basket of goods & services, but the PPI basket focuses on goods & services from industries like utilities, energy, mining, manufacturing, and agriculture.
There are also different types of PPI:
Commodity PPI
Commodity PPI focuses on price changes in specific goods and services. One example would be to track the change in energy prices.
Industry PPI
Industry PPI focuses on changes in prices for specific industries. For example, microchip production or shipbuilding.
Stage-of-processing PPI
Stage-of-processing PPI focuses on differentiating stages of production and tracking how prices change during those stages. For example, how much raw materials cost, the prices for turning those raw materials into intermediate goods, and what are the prices for finished goods. A laptop starts as a bunch of raw materials which are transformed into specific components, which are then put together into a finished product. The price of the finished product is impacted by the price of raw materials and intermediate goods.
Changes in the PPI can also provide an early indication of changes to the CPI. If prices for producers surge, prices for consumers are likely to increase as well.
Central bank policies & inflation
Central banks have significant control over inflation. Many central banks – such as the United States Federal Reserve – seek to keep inflation in around the 2-3% range. Other banks may have slightly lower or higher targets, but price stability is a widespread goal of central bankers.
Central banks seek to manage inflation in the following ways:
Interest rates
Central banks can raise the benchmark interest rate to influence the cost of borrowing. When it becomes more expensive to borrow people tend to spend less money on goods and services. This lowers the demand for goods and services, and brings down inflation. By contrast, when central banks lower interest rates the cost of borrowing declines, leading to more spending on goods and services, more demand, and higher prices.
Open market operations (OMOs)
Central banks also conduct what are called open market operations (OMOs). A central bank will buy government securities from banks, which injects money into the banking system. This ‘creates’ money, meaning there is more money and thus more potential demand for goods. Central banks can also sell government securities – like bonds – which removes money from the system.
Discount rate
Private banks often borrow from central banks. The interest rate charged by the central bank is called the discount rate. By lowering the discount rate, the central bank can lower the cost of borrowing for private banks, which can free up private banks to lend more money and increase demand for goods and services. Alternatively, central banks can raise the discount rate, which increases the cost of borrowing for private banks and can lead to private banks cutting back on lending, thus reducing the amount of money in the system and reducing demand.
Changing reserve requirements
In much of the world, private banks operate on a ‘fractional reserve system.’ This means banks can lend out more money than they actually have. Since most people won’t go to the bank and demand all their money at the same time, this allows banks to increase the money supply through loans. However, the lower the reserve requirement is (the ratio of actual deposits to loans), the more vulnerable a bank becomes to a potential bank run.
Central banks can increase the reserve requirements at private banks, which increases potential stability in the banking system at the cost of reduced lending, a smaller money supply, and lower demand. Conversely, central banks can reduce the reserve requirement, which can increase lending, increase the money supply, and increase demand, while also increasing potential system risk in the banking sector.
Forward guidance
Central banks can issue ‘forward guidance’, where they give either subtle or overt clues as to their future actions. For example, if a central bank hints that they will raise interest rates, this can often cause asset prices to fall and cause people/businesses to reduce their spending in anticipation of higher debt servicing costs. A central bank can achieve the opposite effect by hinting they will cut interest rates, which can cause asset prices to rise in anticipation of lower borrowing costs and increased spending.
Quantitative easing
Considered the ‘nuclear option’ for central banks, quantitative easing involves a large-scale intervention by a central bank in which they purchase a significant amount of government bonds or shares in private companies. Since the money they use to make those purchases is created out of nothing, the money supply is thus expanded and demand is potentially increased. This can increase economic activity in the short-term, but the consequences can be significant. Injecting so much money into the system can significantly distort the economy. Additionally, since quantitative easing is generally used as a tool to fight recessions, it can lead to the survival of companies that should have failed. This prevents the resources of that company from being reallocated in a more efficient way (merger, takeover by more successful competitor, bankruptcy proceedings, etc.), and can lead to a less innovative economy in the medium to long-term.
Why inflation is dangerous
Inflation – especially prolonged periods of elevated inflation – is very dangerous.
Inflation is a hidden tax, because it robs you of your purchasing power. Two years of 10% annual inflation is equivalent to the government increasing your taxes 10% two years in a row. People would be outraged at the latter, but often overlook the former. Governments love this, because they can blame private companies for inflation and direct public anger in that direction, even though inflation is usually caused by governments & central banks, rather than private corporations or private banks.
Inflation also redistributes wealth towards those more closely connected to the government. The creation of new money often benefits those closest to the governmetn and central banks the most. By the time that newly created money reaches most people, prices have already gone up, leaving most people worse off.
As noted above in relation to quantitative easing, inflation – and government efforts to induce inflation – often distorts the economy. Instead of prices being a response to the individual choices and desires of consumers (as is the case when the market is allowed to function freely), government interference means prices are often a response to political whims and the short-term interests of the governing party. This is incredibly damaging to the economy.
Without the right to own property, we are not able to defend individual freedom. Inflation erodes the value of money, which thus erodes the value of our private property. This leads to an erosion of our freedom and a transfer of power away from individuals and toward the government.