What Actually is Inflation?

$10 eggs, $5 gas, $8 coffee, $20 fast-food lunches. The list goes on and on. Everything these days seems so expensive, especially when compared to just a few years ago. Why have the prices of these goods increased? Is it normal? Will they ever come back down? To answer all these questions, we will be discussing the powerful economic force of inflation. 

Put simply, inflation is the change in price over a period of time of goods and services. There are two main kinds of inflation: demand-pull inflation and cost-push inflation.

Before we discuss these two kinds of inflation, let us quickly go over the relationship between supply and demand. Supply and demand are closely related, and the key metric bringing them together is price. The price of a good is the point at which supply and demand for that good are equal.

Consider the supply and demand for red minivans. If the supply of red minivans is far greater than the demand for red minivans, the price of red minivans will fall until the demand is equal to the supply, since a lower price of a red minivan will incentivize more people to buy it.

Let’s say now that red minivans are very trendy, and the current supply cannot handle the current demand. The manufacturers will make more red minivans, but that takes a long time, so in the short term they will increase the price of red minivans until the demand is equal to the supply. 

With this understanding of supply and demand, let us move on to how this dynamic causes inflation. We will start with our first kind of inflation, demand-pull inflation.

Demand-Pull inflation occurs when consumer demand for goods and services is greater than the supply. Naturally, this causes the prices of these goods and services to rise. Demand-Pull inflation is often the result of too much money being added into the economy (more money being printed by the Federal Reserve). This occurs not just for a certain good, like red minivans, but all goods and services across an economy. If everyone has more money, items naturally become more expensive. If hamburgers were still 50 cents like they were in 1960, fast food restaurants would have zero profits! They have to raise their prices to reflect the total amount of money in the economy. This is the driving force of long-term inflation, in other words, it is the reason a hamburger was 50 cents in 1960 and is now $10 (or even more at some places!)

Cost-Push inflation, on the other hand, is when certain events or forces cause certain goods to become more expensive. For example, the 2022 war in Ukraine caused grain prices to increase dramatically since lots of the world’s grain exports came from that region. Similarly, a recent bird flu caused many egg-laying chickens to die, sending egg prices upwards. In these cases, demand is greater than current supply, so the prices of goods increase until there is a balance. Cost-Push inflation is often considered more short-term. Consider the same bird-flu that caused egg prices to go over $10 a dozen - that epidemic has subsided and supply has recovered, causing prices to back down to a semi-normal level.

Since the prices of individual goods and services can fluctuate severely, inflation as an economy-wide metric is usually measured as the average price change in a basket of goods (think fuel prices, food, housing costs, material costs, etc.). However, inflation can also be specific to one good (like red minivans) or a sector (like fuel and energy costs).

Is inflation normal?

Inflation is actually very normal. The United States Federal Reserve (the center for monetary policy in the US) wants there to be inflation at a controlled, desired rate of around 2% per year. Put simply, that means it is the stated goal for the average price of goods and services in America to increase by 2% every year to reflect the increased amount of money in the economy. 

Now you may ask, why does the Federal Reserve print more money every year? Why don’t we just keep the money supply constant? These are two intuitive questions, especially considering how detrimental inflation can be. The answer to these questions lies in the fact that inflation’s opposite, deflation, is much more harmful to an economy than inflation.

The United States is a growing economy, so more money is added to reflect that. If the money supply was held constant, and there were more and more people buying and selling goods, the prices of goods and services would decrease, a phenomenon known as deflation. If something will be cheaper next year, you have no incentive to buy it. Money stops transferring hands, businesses go bankrupt, and the economy crashes. Additionally, consider the value of a car-loan. If you had a $15,000 car loan, and the value of your money is increasing, that $15,000 loan would actually be worth much, much more.

Thus, deflation is often considered a huge economic risk, especially when considering how much consumer spending plays a role in the US economy and how much debt the average US consumer and business is in. 

Sticky Wages and Purchasing Power

Although there are a lot of ways inflation affects the economy, one important aspect to highlight is wages. Although wages and inflation do increase together, the problem many US workers face is that wages are considered ‘sticky.’ This means that they increase slower than inflation, and often take months or even years to catch up.

This happens for many reasons: employers wanting to keep payroll costs low, raises only being once a year (if that!), or even simply because there are too many workers and not enough jobs, so employers have no incentive to raise their wages to match inflation.

This dynamic is best understood when considering that the average US salary has increased drastically over the last 50 years, but many people do not feel like they have enough money to pay the bills after a recent occurrence of high inflation.

The last aspect of inflation that we will discuss is the concept of purchasing power. Purchasing power is essentially how much stuff you can buy with your money. Consider this example: if you had $100 in 1960, you could probably buy almost 200 hamburgers. However, 60 years later, you’d be lucky to get 10 hamburgers with that same $100.

If someone had put $100 under their mattress in 1960 and not gotten it out until 2020, the value of their money would have decreased significantly. They would be able to buy much, much less even though the notional amount of money ($100) is the same. Thus, their purchasing power would have decreased.

A decrease in purchasing power incentivizes those who are financially smart to not let their money sit under their mattress, but rather invest or save it so that their theoretical return would out-pace inflation, and they could preserve the purchasing power of their money.

For example, if you earned 2% a year on $1000 over 5 years, and the inflation rate over that same 5 years was 2% per year, you would theoretically be able to buy the same amount of goods and services as you would have 5 years prior. 

Recap

That was a lot of information, so let’s do a quick recap of the highlights. When you hear on the news that “inflation is rising” or “inflation is high”, it's not that there was necessarily no inflation before, but rather inflation is exceeding the benchmark 2% rate.

The inflation they are talking about (unless otherwise specified) is the average price of the most common goods and services in the US economy. 

The inflation could be triggered by more money in the economy, a key sector experiencing a supply-chain shock, or other events that cause the supply and demand balance to be thrown-off. It's important to remember that inflation is happening constantly, and if you are not investing your money and earning a rate greater than the rate of inflation, your money is actually losing value year over year through lost purchasing power.

Remember, inflation is not always bad, and when under control can often be the sign of a healthy economy.