Inflation

by Stephan Smith on November 15, 2010

Inflation is one of those hot economic terms that seems to inspire great concern and fear for those who know the devastation it has caused to numerous countries. But is that great concern and fear justified; is inflation bad? What is inflation? If you are unfamiliar with what inflation is, then be prepared to be enlightened because I will explain on this page just what inflation is and how it affects an average person.

What is Inflation?

Inflation is the expansion of the money supply in an economy. To be absolutely clear, inflation is an increase in the amount of money in circulation in an economy. I use to believe that inflation is the increase of overall prices of goods and services produced in an economy. However, the increase in prices of goods and services is merely the symptom or result of inflation.

But why do prices for goods and services rise? There are only two reasons why prices of goods and services would increase. The two reasons are supply and demand. If demand for goods and services increases and supply stays stagnate or decreases, then prices of goods and services will increase. The same effect would occur if supply decreases and demand stays stagnate or increases. They are interchangeable for they produce the same end result, price increases.

InflationSupply and demand can be influenced by a number of factors. Let me start with demand first. One factor that can influence demand to increase is by growing an economy’s money supply. When money is created and injected into an economy, more money enters circulation. When there is more money in circulation and there hasn’t been an equal increase in output, the value of the money decreases. Why? Because supply increases and demand does not. When supply increases and demand doesn’t, prices fall, and in this case, the value of money decreases. Now that there’s more money in circulation, money will become easier to come by. More people will have more money. If more people have more money, people can now afford things they normally could not.

Printing Money Leads to InflationSo what does that mean? It means demand for goods and services increases. With all other things being equal and supply stays the same while demand increases, you have inflation or an overall increase in prices for goods and services. If supply starts to increase in response to the increase in demand, then you will have disinflation. Now let’s look at the other side of this equation; supply. One factor that can influence supply to decrease is overall producer confidence. Let’s say that producers start developing a poor outlook of the economy they’re in. Since they feel that the economy would probably deteriorate in the near future, one realistic reaction they could take is to decrease the amount of goods and services they produce in anticipation of a fall in demand; producers would scaling back production. Doing that deceases the supply while demand remains same. If that trend continues, prices will increase. The previous examples are just a few factors that can influence supply and demand.

Central Bankers Believe that a Small Amount of Inflation is a Good Thing

Now that you have a good idea of what inflation is, a common thought that many people have is that all inflation is bad. Some share thoughts like no inflation is best for economic growth or even deflation is acceptable. To many, inflation is also considered a hidden tax; a hidden tax called ‘inflation tax’ (I share this view). But central bankers do not share this thought process. They believe that a small amount of inflation is best for economic growth and price stability. When I say small, I mean an annual inflation rate of around 1.5 to 2.3 percent. Here’s is why I believe central bankers want small amounts of inflation in an economy.

Imagine you lived in an economy that had an annual inflation rate of 2 percent. That means prices are increasing by 2 percent per year for goods and services overall. As a consumer, that would somewhat prompt you to buy whatever you wanted or needed as soon as possible because 1 year down the road, the same goods or services you wanted would most likely be 2 percent more expensive. Because you and millions of other people would rather buy now, the economy grows because people are consuming now rather than later. But hey, even if you did wait 1 or even 4 years, you would most likely still be able to afford to buy the same goods and services.

Zimbabwe Dollar - Hundred Trillion Zimbabwe Dollars

Possibly the largest currency denomination ever produced, EVER
The Zimbabwe Dollar
Denomination One Hundred Trillion Dollars (100,000,000,000,000)
The currency became practically worthless. All thanks to inflation.

If inflation is too high, also known as hyperinflation, then now one wouldn’t be able to afford the goods and services one is custom to in only a few years. Not to mention that the currency runs the risk of becoming completely worthless. If inflation is too low, then it would be less of an incentive to buy goods and service now since prices would rise very insignificantly in the future. Deflation would provide a disincentive for people to buy goods and services immediately for prices would be decreasing in the future. If a majority of people held off from buying goods and services, then that means demand would decrease. If demand decreases, output would decrease and that would lead to a contracting economy. That’s my interpretation as to why central banks would want a small amount of inflation rather than no inflation.



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{ 2 comments… read them below or add one }

Yanga L. Sapepa October 28, 2012 at 12:07 PM

Dear Stephan

Thank you for your insightful, incisive thoughts.

What’s your take on “Gold-Backed” Reserve System. Especially to control inflation? Is it not more moral than the current “Imaginary Value” System? Gold is property, is it not?

Thank you again,

Y

Reply

Stephan Smith October 28, 2012 at 12:40 PM

Hi Yanga,

If the United States or any country were to go to the “Gold Standard”, that country will experience a decline in consumer prices (commonly called deflation) and a contraction in the Gross Domestic Product. Less people will be working and many businesses and people would not receive funding (loans) because there’s a FIXED amount of money in circulation.

Consider this…let’s say there’s only $100 dollars of gold backed currency in an economy. Then there will be businesses AND people who do not get loans because $100 is all there is. There is no printing more because it needs to be backed by gold. So a lot of ideas, plans and projects will be dead in the water because they can’t get money.

Do you see what I’m getting at? There will be economic contraction, there will be an increase in unemployment and there will be deflation. The semi-benefit of a gold backed currency is the following…people will be encouraged to save money because money will increase in value over time and thus the cost of everyday items will get cheaper.

Imagine if you went to the store one day and saw milk was $1.75 and then next month it was $1.24. That would be awesome huh? Yes it would. But lets say you were planning to buy a car for $15,000 and you knew prices would decrease over time. Would you wait a month to see if prices fell? I know I would. Now if everyone in an economy waited for the price to drop, no one would be buying cars now. Then the automobile industry would collapse. There are a lot dangers to going back to the gold standard.

Money is simply a tool used to help the trading of goods and services. That’s it. I personally prefer money to be 100% controlled by people like we have it today, instead of it being controlled by nature (GOLD). Now I’m not saying I like what people are doing with money now, but I do like that we control it 100%.

Gold could possible lead to inflation as well. Let’s say we find a HUGE MINE filled with billions of tons of GOLD. Boom…inflation. Thanks for your comment.

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