What is Inflation?
Inflation Overview
Inflation is the decline of purchasing power of a currency over time. The rate at which the value of the currency is falling and the general level of prices for goods and services is rising.
“I think inflation is pretty easy to explain and people need to know what causes inflation. The federal government gets debt, then the Federal Reserve prints up new money to pay for the debt, that new money enters circulation, and that expansion of the money supply leads to inflation.”
-Senator Rand Paul
Details on Inflation
An increase in the supply of money is the root of inflation. Money supply can be increased by the monetary authorities either by printing and/or giving away more money to individuals. In cases of money supply increase, the money loses its purchasing power.
There are 3 types of inflation:
Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. This increases demand and leads to price rises.
Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channeled into a commodity or other asset markets and especially when this is accompanied by a negative economic shock to the supply of key commodities, costs for all kinds of intermediate goods rise.
Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs or wages to maintain their standard of living.
There are 2 primary measurements of inflation:
Depending upon the selected set of goods and services used, multiple types of baskets of goods are calculated and tracked as price indexes. The most commonly used price indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
The CPI is a measure that examines the average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care.
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. For example, it includes the price of raw materials such as cotton, oil and timber.
A country’s financial regulator shoulders the important responsibility of keeping inflation in check. It is done by implementing measures through monetary policy, which refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.
In the U.S., the Fed's monetary policy goals include moderate long-term interest rates, price stability, and maximum employment, and each of these goals is intended to promote a stable financial environment. The Federal Reserve clearly communicates long-term inflation goals in order to keep a steady long-term rate of inflation, which is thought to be beneficial to the economy.
Inflation Conclusion
Too much inflation is generally considered bad for an economy, while too little inflation is also considered harmful. Many economists advocate for a middle-ground of low to moderate inflation, of around 2% per year. Generally speaking, higher inflation harms savers because it erodes the purchasing power of the money they have saved. However, it can benefit borrowers because the inflation-adjusted value of their outstanding debts shrinks over time.
Happy Trading, Verdia
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