Basics of Inflation
Why do prices change?
Inflation
Inflation is the relationship between money circulating in an economy to the goods available to buy in an economy.
(How much money is there compared to stuff to buy?)
Inflation rises when the money in circulation grows compared to goods produced. In the same logic, when fewer goods are produced but the money in circulation remains the same, inflation still rises. The Inflation Rate is about the change between these two factors over a set period of time. When the Inflation rate is negative, prices are falling, we call this deflation.
What is money in circulation?
Money that is actively "moving" through the economy. Money being spent, earned, loaned, or otherwise used in transactions. If you buried $1,000 in cash in your backyard and vow to never spend it, you have removed it from circulation. (Your bank account does not count as the bank loans up to 90% of the money you deposited)
What are goods produced?
Goods are products you can buy, like cars, food, cell phones, houses, steel, etc. When more goods are produced compared to money in circulation, each good is worth less. Therefore, prices for each good falls.
Who are our players?
These are the forces that influence inflation/deflation (Simplified)
The Federal Government
I tax, spend and control money
The Federal Reserve
I print and spend money
Producers
I make things to spend money on
Consumers
I spend money
How do prices rise?
Let's look at some examples in history, we'll be looking from a largely American perspective.
First half of the 2020's
Initially the Coronavirus pandemic caused a sharp drop in prices, sparking concerns about rapid deflation and wage decreases, the Federal Reserve quickly dropped interest rates to near 0% and announced $700 billion in spending with the goal to stabilize the economy. The following shutdowns and shortages resulted in a sudden drop in the amount of goods produced and available, putting upward pressure on prices. This would cause the Fed to react slowly, thinking that once shortages ended, inflation would return to normal. claiming that rising inflation is "transitory" meaning temporary, it wasn't. Only raising rates once prices were already rising dramatically. Simultaneously, large amounts of government stimulus spending led to a second flood of money into the economy. Contributing to Inflation peaking at 9.1% in June 2022.
The Great Inflation (1965 to 1982)
Four recessions, Energy Shortages and Large Government spending programs, and the end of the last remnants of the gold standard helped to drive inflation upwards. The Federal Reserve did not have an inflation target as official policy back then, focusing only on maximizing employment.
WW1 and WW2
Heavy borrowing to finance war spending along with the shocks once the wars ended drove up prices. When most of the countries industrial capacity is going towards making war material instead of regular consumer goods, it's easy for the money in circulation to grow faster than good available. Not to mention the goods produce being destroyed in war.
How do we measure Inflation?
There are two primary metrics the U.S Government uses to measure inflation, specifically from the Bureau of Labor Statistics (BLS)
- CPI Consumer Price Index
Imagine a basket full of goods the average person would buy
- PCE Personal Consumption Expenditures
Important note about recent years:
Individuals appointed by the Trump administration have been accused of manipulating these measurements, prioritizing political loyalty rather than statistical accuracy.
Inflation as a political tool
In many developing nations where politicians directly control the money supply, they will use money to buy votes and ensure they win elections. For example, here in my fictional town of Calium we're having elections soon, I'm the president and things haven't been going well recently (especially for the large poor population) and I think I may lose. So I decide to rapidly expand the welfare state, raise everyone's wages and offer cheap credit to anyone to buy houses or starting businesses. I pay for this using my money printer, flooding the economy with money, in the short term this is great, people can afford to buy the things they want, business expand and retirees are taken care of and most importantly I win re-election.
As the months pass however, all this new money in circulation is putting pressure on prices. People, banks and businesses need to pay back the loans that are coming due. Poor people rapidly spent their money, they could hardly afford to save if at all.
- TLDR: Give money to make things better now! Who gives a damn about the future, that's the next guys problem!
Remarks and Opinions
Like most things, inflation and deflation are not inherently good or bad. It's the sudden change in either one that is bad. Shocks are generally bad in economics, economists try to predict the future. Swings in a variable can dramatically change what we expect to happen,
[1] https://www.federalreservehistory.org/essays/great-inflation [2] https://www.clevelandfed.org/center-for-inflation-research/inflation-explained-your-guide-to-inflation-basics/how-is-inflation-measured [3] https://www.reuters.com/world/us/us-transitory-inflation-turns-five-is-still-big-brat-2026-03-17/ [4] https://www.cnbc.com/2020/03/15/federal-reserve-cuts-rates-to-zero-and-launches-massive-700-billion-quantitative-easing-program.html
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