Inflation: A Qualitative Look at a Quantitative Measure
By Andrew Shaughnessy
Inflation can be a confusing and scary concept for consumers and businesses alike. It brings to mind visions of skyrocketing prices, waiting in around-the-block lines for gas, and plummeting standards of living. While inflation in the United States has stayed relatively low and stable since the 1980s, some economists worry that the ongoing trade war with China will raise prices and stoke inflation anew. Meanwhile, average wages haven’t kept up even with the country’s moderate cost-of-living increases. By some estimates, the average worker’s inflation-adjusted pay today is nearly 9% lower than in 2009. Combine that with low unemployment rates, and some experts say you’ve got yourself a recipe for inevitable pay hikes that will fuel inflation in a vicious cycle of wages and prices continually rising to meet one another.
Simultaneously, plenty of other economists argue that there is nothing to worry about. Inflation has been low and stable for decades, the Federal Reserve has everything under control, and America’s economic future looks bright and sunny.
So what does it all mean? What is inflation anyway, and how does it work? What can we learn from the past as we look to the future? And what does it all mean for local companies and consumers?
What Is Inflation?
In simple terms, inflation is the rate at which the average price of goods and services in an economy increases over time. If the price of apples goes up from one month to the next, that’s not inflation. If the price of apples, gasoline, rent, shampoo, medical care, college tuition, cigarettes, and blue jeans goes up from one month to the next, that’s inflation.
One of the primary tools economists use to measure inflation is the Consumer Price Index (CPI). The CPI measures the average change in prices over time for a “basket” of goods and services that a typical urban household uses – things like coffee, shampoo, rent, and medical care – and churns out a measure of inflation relevant to you and me. As these prices go up, the purchasing power of your dollar goes down. In other words, rising inflation means a rising cost of living. The higher the inflation, the faster the cost of living rises.
There are a number of common causes for inflation:
In demand-pull inflation*, inflation rises when demand for products or services goes up and producers respond by increasing prices. For example, let’s say that a shoe company releases an innovative new running shoe, and they’re flying off the shelves. The shoe company may increase their prices to meet the high demand.
In cost-push inflation*, prices go up because the cost of production goes up. For example, if there is an increase in the cost of raw materials needed to make popsicles, or if the mandatory minimum wage rises and popsicle artisans receive pay raises, a popsicle shop may increase its prices to maintain profit margins.
Built-in inflation is essentially a vicious cycle of increasing prices and increasing wages responding to one another. When prices of goods and services go up through demand-pull or cost-push inflation, the workforce may demand an increase in wages in order to keep up with the rising cost of living. This increases the cost of production for employers, and they respond by again raising prices to maintain profit margins (cost-push inflation). Past inflation causes future inflation ad infinitum.
Inflation can also be caused by an increase in the money supply, such as when a government prints more currency. The extra currency in circulation can decrease the value of the dollar and lead to higher prices for foreign goods. Domestically, when the money supply increases at a faster rate than output, it causes greater demand for goods and services, which in turn leads to higher prices.
*With these examples, inflation is caused by the net effect of many producers experiencing these same causes and raising prices.
So, Is Inflation Good or Bad?
Since rising inflation means higher prices and a higher cost of living, most people assume that inflation is simply and always bad, but the truth is a bit more complicated.
In the short term, businesses that sell products or provide services actually can benefit from inflation. Higher prices for their product or service can make for higher profits. “Inflation brings a lot of benefits to a lot of individuals,” says Lee University business and economics professor Dr. Hermilo Jasso. “If you are the seller and inflation is going up, then you’re going to get more revenue for selling the same product.”
In the long run however, the cost of production will rise – typically via pricier raw materials or higher wages – meaning that the negative impact of inflation eventually hits producers too.
That being said, inflation is necessary for a healthy economy. Because inflation causes cash to lose value over time since it increases prices, individuals are incentivized to spend rather than save, thus stimulating overall economic growth.
“Policy makers tend to target an inflation rate of around 2%,” explains UTC Department Head of Finance and Economics Dr. Bento Lobo. “Some inflation is deemed good. It allows firms to increase their revenues, helps raise taxes for state and federal governments, and usually is also accompanied by a rise in wages. If inflation is controlled at a low and manageable level, it can be a good thing all around,” he adds.
Inflation in Action: A Historical Perspective
Of course, inflation doesn’t always stay low and under control. If inflation becomes negative (deflation) or rises over 50% per month (hyperinflation), it can create problems and negatively impact the economy.
One of the most famous examples comes from post-World War I Germany – the Weimar Republic. Banking on victory and repaying debts with the spoils of war, the German Empire borrowed heavily throughout the conflict to fund their efforts. When Germany lost the war, their new Weimar Republic government found itself saddled with a gutted economy and huge war debts, forced to pay crippling reparations to the victors. They began rapidly printing money to pay these debts, causing massive hyperinflation and skyrocketing prices for basic goods. At its peak, hyperinflation reached 29,500% per month in October 1923. As the stories go, the German mark became so worthless that people began burning currency notes to stay warm rather than buying firewood or coal.
In another famous example, Zimbabwe’s inflation rate reached 89 sextillion percent in November 2008, the second highest hyperinflation rate ever. Following a significant drop in economic output and exports, the Zimbabwean government began to spend heaps of money to placate the people. Soon they were mired in national debt. With the economy crumbling and debt increasing, the government needed cash – fast. So they simply created and began to print a new currency, the “New Zim dollar.” As more and more currency entered circulation, its value dropped, and inflation skyrocketed.
At its height, inflation was so bad that prices of basic goods would double every day.
While inflation has been steady and low in the U.S. for nearly four decades, stability has certainly not always been the status quo.
Our country’s first bout with hyperinflation came before the nation had even formed. During the American Revolutionary War, the Continental Congress needed cash, but couldn’t exactly levy taxes yet, so they printed and distributed their own paper money – the “Continental dollar.” The scheme briefly worked, but the currency was not backed by gold or silver. As the government continued to print more money, the Continental rapidly diminished in value. By the early 1780s, the nearly useless paper notes were discontinued.
Having learned firsthand the perils of haphazardly printing a currency not backed by physical reserves, the United States spent most of the next 200 years desperately trying to fix the price of the American dollar to a specified amount of precious metal held by the treasury. In 1785, the U.S. adopted a silver standard, basing their new silver dollar on widely used Spanish pieces of eight. In 1834, they switched to the gold standard, directly linking the value of paper money to gold reserves.
During the Civil War, both the Union and the Confederacy experienced inflation as they printed money not backed by gold reserves to fund the war effort. By the early 20th century, the gold standard began to fall apart. The U.S. created the Federal Reserve in 1913, looking to stabilize the value of gold. This began an era of frequent government economic intervention.
In the 1930s, the Great Depression brought the
opposite problem: deflation. When the stock market crashed in 1929, consumer spending and investment dropped dramatically, kicking off a vicious economic cycle.
“Companies were not able to sell their products, so they began to lower the price and lower the price, but people were hoping that the price would go even lower, so they just waited,” explains Dr. Jasso. “It became a self-fulfilling prophecy. Many companies were not able to make money, so they let go of workers. So now with no consumption, there’s no production; no production, no labor; no labor, no income; no income, no consumption – and the cycle goes on.”
When the United States entered World War II, manufacturing and industrial production expanded, and unemployment dropped. Massive defense spending raised prices and caused high inflation for several years, but the government took steps to regulate price and wage increases, largely keeping inflation under control.
The United States’ most recent period of great inflation occurred from the 1970s through the early ‘80s, known as the Great Inflation. Many theories have been batted around as to the primary reason for the inflation, and a single cause is difficult to pin down. One significant source was political. Leading up to the 1972 election, President Nixon urged the Federal Reserve to keep interest rates low to stimulate the economy, decrease unemployment, and win voter approval. At first the tactic seemed to work, but it soon contributed to the spiral of rising inflation.
Another piece of the puzzle came with the demise of the gold standard, officially ending in 1973. By the ‘70s, the global economy had grown such that the U.S. could no longer match dollars with gold. When inflation sparked a gold rush, Nixon scrapped the system of foreign markets trading in dollars, and soon the global gold standard was tossed to the dustbin of history. The loss in confidence in American economic stability further stoked the Great Inflation.
Simultaneously, the Organization of the Petroleum Exporting Countries (OPEC) was attempting to create a monopoly on oil pricing. Foreign members of OPEC imposed an oil embargo against the U.S. and other countries, banning petroleum imports and significantly cutting oil production. By decreasing the oil supply and quadrupling prices, a supply shock was created, further contributing to economic decline.
Did You Know?
During the Oil Crises of the 1970s, gas was in such short supply that not only did drivers try to fill up late at night or early in the morning to avoid lines, but odd-even rationing was introduced. This meant that if the last digit of your license plate was odd, you could only get gas on odd-numbered days. The maximum speed limit was even reduced to 55 miles per hour to cut energy consumption and conserve gas.
Will History Repeat Itself?
Since the 1980s, the inflation rate in the U.S. has been fairly stable, but some worry that history is bound to repeat itself. After all, an economy can only remain strong and steady for so long, right? Should businesses and individuals worry about hyperinflation looming in our near future?
Most experts say ‘no.’
“We are not another Zimbabwe in the making,” says Dr. Lobo. “In fact, over the past three years, the Federal Reserve has been in a position to raise rates and simultaneously take some money out of the system and shrink its balance sheet. So, I don’t think hyperinflation is a concern that people should have.”
Dr. Jasso agrees. “The United States is the strongest economy in the world, our currency is the strongest currency in the world, and we have a great Federal Reserve Bank that intervenes in the economy to deal with the cycles that are taking place,” he says. “The future looks positive.”
Today, U.S. population growth is low, which is a key driver for demand and GDP growth. The global economy is expected to further raise competition, which will continue to place downward pressure on prices for raw materials and finished goods.
Technological progress has and will continue to play a major role in controlling inflation. As new innovations and technology require fewer staff and skilled workers and improve productivity, fixed and variable costs related to output will continue to decline and offset other inflationary pressures.
Beyond that, other factors like the “sharing economy” (estimated to be worth $335 billion by 2025) will continue to help control inflation as consumers choose to share and reshare goods and services and conduct business peer to peer with no middlemen involved. Think: Uber, Airbnb, Etsy, Bellhops, and more. With consumers capitalizing on the unused capacity of idle goods and services, demand for new products and services is reduced, prices remain lower, and inflation is further controlled.