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.
Supply 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.
So 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.
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.