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Inflation

The Dynamics of Rising Prices and Reduced Purchasing Power

 

Inflation is a monetary phenomenon wherein prices broadly rise and consumer purchasing power declines over time. From a practical perspective, it means your dollar doesn’t stretch as far as it did the day before.

Inflation is frequently mentioned in discussions about the economy, financial planning, and the cost of living. It is a complex phenomenon that can have significant impacts on the economy, businesses, and individuals. It has a significant negative impact on retirement resources.

In the US, the inflation rate has generally been around 2%-3% per year since 1960, with a handful of notable spikes, and prices have risen nearly continuously since then. A dollar one century ago was worth $18 in 2024 terms.

Several factors can cause inflation, and these are typically categorized as demand-pull inflation, cost-push inflation, and built-in inflation.

Demand-Pull Inflation occurs when the demand for goods and services exceeds their supply. When consumers have more money to spend, their increased purchasing power can drive up prices as businesses struggle to meet the higher demand.

Cost-Push Inflation happens when the costs of production for goods and services increase, leading businesses to raise prices to maintain their profit margins. Key drivers of cost-push inflation include rising labor costs, increases in the prices of raw materials, and supply chain disruptions.

Built-In Inflation is also known as wage-price inflation, this type of inflation is linked to adaptive expectations. As the cost of living rises, workers demand higher wages to keep up with the increasing prices. Businesses, in turn, pass on the higher wage costs to consumers in the form of higher prices, creating a feedback loop.

Inflation is typically measured by the Consumer Price Index (CPI) and the Producer Price Index (PPI).

The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It is a widely used indicator of inflation and is often used to adjust wages, pensions, and social security benefits for inflation.

The Producer Price Index (PPI) measures the average change over time in the selling prices received by domestic producers for their output. It is a measure of inflation at the wholesale level and can provide early indications of future consumer price inflation.

Inflation can have a wide range of effects on the economy and individuals. One of the most direct effects of inflation is the erosion of purchasing power. As prices rise, the value of money decreases, meaning consumers can buy less with the same amount of money.

Inflation often leads to higher interest rates, as central banks, such as the Federal Reserve, increase rates to curb the inflationary pressures. Higher interest rates can impact borrowing costs for consumers and businesses, affecting everything from mortgages to business loans.

Inflation can influence wage negotiations, as workers seek higher pay to keep up with the rising cost of living. This can lead to a wage-price spiral, where wages and prices continuously push each other higher.

Inflation can erode the real returns on investments. For instance, if an investment yields a 5% return, but inflation is at 3%, the real return is effectively only 2%.

 

Economists and policymakers employ various strategies to manage inflation and its effects.

Central banks use monetary policy to control inflation. This includes adjusting interest rates and using open market operations to influence the money supply.

Governments can also use fiscal policy to combat inflation. This includes adjusting tax rates and government spending to influence economic activity.

Some central banks adopt inflation targeting, where they set an explicit inflation rate as their goal and adjust their monetary policy to achieve that target.

In the US, some inflation is built into federal monetary policy. The Federal Reserve, the country’s central bank, targets 2% inflation. The number is somewhat arbitrary but is intended to maintain a predictable and low rate of rising prices, allowing companies and households to plan for the future.

Economists also worry about deflation. While falling prices and a stronger currency may seem positive, they can spark a deflationary loop. In such a scenario, demand drops as consumers expect prices to continue falling, which causes profits to fall and unemployment to rise, leading to falling incomes and further decreasing demand.

Those in charge of monetary policy therefore seek a delicate balance between demand and supply to promote small inflationary effects in the economy.

Inflation in the US can generally be split into two eras—before and after the establishment of the Federal Reserve, the US central bank. Prices remained relatively constant until around the mid-1920s, after which they rose dramatically to the modern day.

Exact inflation rates in early America are difficult to calculate precisely, though the highest inflation in US history was said to be in 1778, just after the Revolutionary War, at close to 30%. Both World Wars brought double-digit inflation, while the Great Depression saw severe deflation as the money supply shrunk by 30%.

In the 1970s, the US experienced what is known as stagflation, or the combination of inflation, high unemployment, and slow economic growth. Policymakers at the Federal Reserve embarked on a yearslong strategy of high interest rates to tighten the money supply.

Under certain conditions, prices can undergo rapid increases resulting in hyperinflation. Venezuela, which has suffered long-running inflation since the 1980s, has seen extreme runaway prices since 2018 as citizens lost confidence in the national currency as a store of value.

Economists largely agree that some small, stable amount of inflation is desirable, and most central banks set inflation targets that they attempt to control via the interest rates and money supply. Still, global economies remain subject to large-scale events that can trigger inflation—wars, natural disasters, pandemics, supply chain disruptions, and more.

Inflation is a multifaceted economic phenomenon that affects everyone in different ways. Understanding its causes, measurement, effects, and management is crucial for making informed economic and financial decisions. By keeping an eye on inflation trends and adopting strategies to mitigate its impact, individuals and businesses can better navigate the challenges and opportunities it presents.

 

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