What Is Inflation and Why Is It Important?

An infographic that defines inflation and explains different types of inflation

“In the simplest terms, inflation occurs when there’s too much money in the system. On the flip side, deflation occurs when there are too few dollars in circulation.”

Robert Kiyosaki

Inflation: What Is It and How Does It Affect Me?

Inflation is the decline of purchasing power of a currency over time. As economies expand, people start making more money and start spending more money. As aggregate demand in an economy increases, so does the demand for money. For various reasons, central banks of different countries will increase the money supply in their nations. For example, in the U.S., the Federal Reserve determines through its monetary policy, if they need to issue more money.

The Fed’s decision to increase the money supply and by how much is based on various factors. Economic growth, investment levels, and foreign debt owed are just some of the reasons the Fed might want to increase the money supply. However, when the Fed increases the money supply, it has to make sure it does so in a controlled way. Too much money in the system creates excess aggregate demand and increases inflation. However, too little money in the economy will reduce demand, cause deflation and hurt economic growth. The primary goal of the Fed is to monitor inflation and keep it at a target rate of about 2%.

Inflation can affect almost every product, service, and industry. When it becomes widespread, it will affect everyone in the economy and it will reduce consumer confidence. People start worrying about the increase in livings costs and how they can save enough for retirement.

When more money is printed and put into circulation, the currency loses a little bit of its value. Because of this, the price of goods and services goes up. This means that you can buy less with $1 than before. This decline in purchasing power is called inflation. Here is an example of the decline in purchasing power.

Just because the price of goods and services has gone up doesn’t mean your employer will pay you more money. Here is an example. It is January 2021, and the U.S. federal minimum wage is $7.25 per hour and has been so since 2009. However, the cumulative inflation rate from 2009 to 2021 is about 25%. So what used to cost $1 in 2009, likely costs about $1.25 today. Or a $10,000 car in 2009 now costs about $12,500 today.

With as much consumer spending as there is in the U.S., a 25% price increase is huge. That adds up over time, especially since federal minimum wages have stayed flat. The disparity between the increase in the cost of goods and services and stagnant wages directly affects your cost of living.

What Are the Different Types?

There are four different types of inflation, characterized by the pace at which they are occurring:

  1. Mild inflation: This happens when goods and services across the economy increase at a very slow pace. Typically less than 3% per year.
  2. Walking inflation: This type typically sees a 3 % – 10% rise in the price levels of goods and services. While not ideal, it is not uncommon for annual rates to rise at these levels periodically.
  3. Galloping inflation: This only happens when the price of goods and services rises at a rate of more than 10% per year. This rarely occurs in developed economies with strong monetary policies.
  4. Hyperinflation: This occurs when goods and services increase by 50 % or more in a given year. Periods of prolonged hyperinflation can wreak havoc on the economy.

What Causes Inflation?

The root cause of inflation is the increase in the money supply. As mentioned before, the money supply is controlled by the government and the Federal Reserve in different ways. They can simply do this by printing more money and either giving it away, devaluing its currency or by decreasing interest rates resulting in cheaper borrowing. No matter how it is done, an increasing money supply typically results in a loss of purchasing power. This is not always bad. A rate of 2% is completely acceptable as long as the economy is growing at a healthy rate.

There are several ways that the increase in the money supply can cause inflation. Here are the most significant ones.

Demand-Pull Inflation

Demand-pull inflation is the result of an increase in demand for goods and services. This occurs when an increase in the money supply, stimulates an economy’s aggregate demand to a level that outpaces its aggregate supply. This can happen because people have access to more money or because governmental policies aim to incentivize the consumption of goods.

For example, every time the Fed lowers interest rates, consumer and business spending increases. Good examples of government policies that incentivized consumption are the various Covid Relief Bills that passed in 2020. These bills brought relief to consumers and businesses, increased consumption, and reduced the length of the recession. Another way the government can increase consumption through fiscal policy is by implementing tax cuts and offering tax incentives.

Cost-Push Inflation

Cost-push inflation results from an increase in the cost of goods and services.

The first reason is the increase in costs of in the supply of goods and services. This can happen because the products/services become more expensive to produce or because government policies restrict access to the goods. Factors such as an increase in minimum wages, higher tariffs on imports, and an increase in the cost of raw materials, will make products more expensive.

Why Is It Necessary?

Simply put, inflation is a ‘necessary evil’ that keeps the economy in check as long as it occurs in moderation. We want to point out now that there are times where rapid inflation can ruin an economy. Look at Zimbabwe’s Hyperinflation, when $10 at the beginning of the year was worth the same as $100 billion dollars later in the year.

When properly used and calculated, inflation helps the economy by bolstering a “buy now” mindset. If you need a new refrigerator soon, and you expect prices to rise over time, you’re probably going to buy it sooner rather than later. This type of mindset keeps the economy going. Obviously, there are times when it’s fiscally smart to wait, but, as a whole, consumers will usually buy now rather than later. This buy-now movement keeps stores selling more items, factories and manufacturers producing more items, logistics chains delivering more items, and so on.

Another way inflation helps us out is by reducing the risk of deflation. If the government doesn’t intervene with controlled inflation, economies run the risk of a decline in demand for products (because if prices will drop in the future, why should we buy now?) which, in turn, creates a lower demand on factories, logistics, and the entire supply chain down the line.

Finally, most debt is calculated based on an interest rate set by the government (“The Fed Rate”). This interest rate itself is based on the inflation rate. Having debt calculated this way makes it easier for consumers and businesses to pay off their debt by creating a system where the debt loses value over time. If there is no inflation, then interest rates on debt have no room for reduction and, without increased wages, this makes it tough for debt to be paid off properly.

Can You Make a Profit on Inflation?

Of course, you can! In fact, without it, many investors, firms, and hedge funds simply would not exist. Let’s take a look at a few examples:

  • Real Estate – Inflation increases property values. This steady rise in values creates a real estate market that, over time, typically has appreciating assets.
  • Commodities – When inflation goes up and causes a currency to lose value, many investors turn to commodities, whether precious metals like gold or livestock like pork belly.
  • Stocks – If a steady inflation rate creates increased consumer demand, stocks from the right companies (supply, manufacturing, logistics, etc.) will typically, on average, keep rising as inflation goes up.

How Does Inflation Affect Consumption?

Some people love it, some people hate it, and the third group of people doesn’t even know it exists or doesn’t care about it. Regardless of your personal stance on the matter, just about every economist agrees that inflation is a necessary evil to maintain a healthy economy. When it increases, people expect prices of products to go up in the future. Consequently, they buy the products they need today versus deferring the purchases indefinitely into the future. This spurs more economic activity, more production of goods and services, and an increase in wages.

Formula

Inflation formula

Inflation, often mathematically represented by Pi, is calculated as the difference between the consumer price index (CPI) for the current year (represented as CPI(X+1)) in the formula above and the consumer price index for the previous year (represented as CPI(X)), divided by the consumer price index for the previous year (CPI(X)). Generally speaking, the US rate falls between 1% and 5% per year. The BLS (U.S. Bureau of Labor and Statistics) tracks a basket of goods that it uses to calculate and publish inflation data every month.

Conclusion

Inflation is very different from the change in the price of a specific good or service, which we all know changes all the time. The price of oil, for example, may change daily. That has nothing to do with inflation. For inflation to occur, two things must be true: there must be a general price increase in goods and services across all categories and a reduction in the purchasing power of the people.

Other reading:

The Federal Reserve does a great job of explaining inflation.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.