What is Inflation?
The measure of price increases within a set of goods and services over a period of time is known as inflation. The most common gauge of inflation is known as the CPI, or consumer price index, which measure the price increases (decreases) of basic consumer goods and services. The GDP deflator is another very important measure of inflation as it measures the price changes in goods that are produced domestically. In effect, inflation decreases the value of your money and makes it more expensive to buy goods and services.
Causes OF Inflation
There are a few different reasons that can account for the inflation in our goods and services; let's review a few of them.
- Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand.
- The cost-push theory , also known as "supply shock inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump.
- Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the Federal Reserve does not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with a high levels of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis of 2007 is a very good example of this at work.
- Inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services. This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation will continue to rise.
Effects OF Inflation
The effects of inflation can be brutal for the elderly who are looking to retire on a fixed income. The dollars that they expect to retire with will be worth less and less as time goes on and inflation goes higher.
When the balance between supply and demand spirals out of control, buyers will change their spending habits as they meet their purchasing thresholds and producers will suffer and be forced to cut output. This can be readily tied to higher unemployment rates. When extremes arise in the supply/demand structure, imbalances are created.
The mortgage crisis of 2007 is a great example of this. Home prices were increasing at a very rapid rate from 2002 to 2005 and got to the point where the prices became too high, forcing buyers to step aside. This lack of demand forced sellers to drop prices back to a point where there is demand. As I write this article, this equilibrium has still not come into the real estate market. This is due to many factors, as you will read in our mortgage crisis article, but the extreme acceleration of inflation in home prices is directly correlated to the pullback we are seeing.
A similar example can be seen in the internet euphoria in the stock market back in 1998 to 2000. This rapid acceleration in stock prices eventually became unsustainable and led to a disastrous fall.
The point that is being made is that if inflation is not contained and rises at an unsustainable rate; the stronger the impact on the other side. There is a saying; "the bigger they are, the harder they fall".