In the most general sense, inflation is a rise in the average price of goods over a period of time. The rate that prices increase is known as the inflation rate. Inflation happens either when prices go up or when it takes more money to buy the same items. Economists typically consider inflation to occur when the prices increase over a period of time rather than from one month to the next.
Inflation and the Consumer Price Index
The U.S. Consumer Price Index (CPI) measures the average change in prices over time for certain consumers for a certain group of goods and services. To determine CPI, the government chooses a base year (right now it’s 1984) and sets the CPI for that year at 100. Then, they choose a group, or basket, of consumer goods and services. Each year, the Bureau of Labor and Statistics (BLS) surveys different areas around the U.S. for the price of that basket. When the price of the basket changes relative to the base year, the CPI also changes. For example, if the price of the basket was $100 in 1984 and increased to $195 in 2009, the CPI would be 195.
CPI is not the same as inflation. Inflation is the change in CPI over a period of time. It can be calculated as [CP1 Year 1 – CPI Year 2]/CPI Year 2, where Year 1 is greater than Year 2. Using the example above the inflation rate from 1984 to 2009 would be 95%. That’s (195-100)/100.
Using CPI isn’t necessarily an indicator of the specific inflation rate for any given consumer since the goods and services you purchase may not be included in the basket. Instead, CPI and the inflation rate is an approximate value for the country as a whole.
What Causes Inflation?
Monetary inflation happens when the amount of money in circulation increases faster than the quantity of goods in circulation. The government is the only entity who can do this. In the old days, they would simply print more money. Today, the government purchases securities from banks, thereby increasing the money supply.
Monetary inflation is often followed by price inflation – the inflation that most consumers can see and identify. Obviously, price inflation happens when the price of goods increases. When there is an increase in money circulation, the value of the dollar goes down. Subsequently, businesses must increase the price of goods to get the same value from their products.
What’s Bad About Inflation?
Inflation can eventually lead to deflation, which is explained below. In theory, people would spend less money when prices are rising, but that’s not always what happens. In practice, people spend the money now because they believe the prices will be higher in the future. If they don’t have the money for desired purchases, then they borrow it. But, inflation makes lending money less attractive because once the money is repaid, it’s not worth as much as itnwas when it was loaned. It could even be worth less. To combat this, banks end up charging higher interest rates on credit and loans, which makesnborrowing more expensive and unattractive.
Another downside to inflation is that it puts some goods and services out of reach for consumers. Rarely do wages increase the same rate as inflation, so consumers have less money to spend. As the gap between income and expenses closes, so does spending. That situation could eventually lead to deflation.
In general, deflation is when the average price of goods falls. When the inflation rate falls below zero, indicating negative inflation, we know that there has been deflation. Remember that the inflation rate is calculated based on the change in the Consumer Price Index, or CPI.
What Causes Deflation?
There are four situations that cause deflation.
1. A decrease in the supply of money. Let’s say the only goods available in the world were green apples, and everyone wanted an apple just as much as everyone else. If we only had $10, then each apple would be worth $1. But, if our money decreased to $5, then each apple would only be worth $.50.
2. An increase in the supply of goods. In the same situation as above, let’s assume the number of apples went up to 20, but we still only had $10. In that case, the value of each apple would again be $.50.
3. A decrease in the demand for goods. If everyone already had an apple, then no one would want to use their dollar to buy an apple. The value of an apple falls.
4. An increase in the demand for money. When the demand for more money increases, it’s symptomatic of people starting to hoard money. The value of the apples falls in relation to the dollar.
Although deflation is generally considered a negative thing, it is not always bad. Wells Capital Management chief investment officer, James Paulsen once wrote that good inflation happens when businesses can produce goods at lower costs without losing profits or raising unemployment rates. This type of deflation would fall under situation 2, an increase in the supply of goods.
Negative Effects of Deflation
Deflation can be a bad thing for consumers and the economy as a whole. For one, debtors end up paying back debts that were borrowed with higher-valued dollars. This effectively increases the amount of the debt. When prices go down, consumers delay purchases thinking that prices will continue to fall. As a result, companies make less money, leading them to layoff employees. When unemployment increases, there is lower demand for products because unemployed consumers can’t afford more purchases. It can become a vicious cycle.
Inflation vs. Deflation
It’s possible for the economy to be experiencing inflation and deflation at the same time. Seldom do the prices of goods and services all increase or decrease simultaneously. Instead, some prices will go up over a period of time, while other prices go down. In that case, there can be inflation and deflation happening at the same time.
One of the government remedies for deflation is to put more money into supply by purchasing securities. Increasing the money supply too quickly can lead to inflation and even hyperinflation, a situation in which inflation happens very rapidly.
Inflation and deflation are both parts of a properly functioning economy. They typically happen in cycles and can correct themselves without any government intervention. However, in extreme situations, like the Great Depression, the economy does need a helping hand from the Feds.