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Politics & Society

What Is Inflation in Economics?

Written by MasterClass

Dec 15, 2018 • 4 min read

Inflation is a force that affects everyone’s lives—even if they’re not aware of it. When prices rise too much—or prices rise but paychecks don’t—people see a negative effect on their purchasing power and quality of life. That’s the most immediate way inflation affects us all.

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Written by MasterClass

Dec 15, 2018 • 4 min read

What Is Inflation?

Spilled jar of coins and money
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Inflation is the steady increase in the price of goods and services over time. It devalues units of currency (like the dollar), resulting in consequences like higher cost of living. Think about how much a candy bar cost when you were a little kid. Now, think about how much that same candy bar costs today. Or, think about how much it cost to rent an apartment in New York City in the 1970s. Now think of how much it costs today. That difference in price is inflation.

The Impact of Inflation in Economic Terms

A stable economy needs a stable level of inflation. Economists understand that while high inflation is a real danger, low inflation is dangerous as well. Just as high inflation can lead to permanently high interest rates, low inflation can lead to permanently low interest rates. Permanently low interest rates limits the Federal Reserve’s (or the Fed’s) ability to increase the strength of the economy in very bad times, which can lead to long, deep Recessions.

Tracking Inflation With the Consumer Price Index

The Consumer Price Index (CPI) is the way the US Bureau of Labor Statistics measures inflation. They survey 23,000 businesses and record the prices of 80,000 items every month to log fluctuations and increases in goods and services. These include:

Retail
Transportation
Gas prices
Health care
Food
Housing
Education

The Consumer Price Index tracks US inflation rates along with their impact on cost of living and purchasing power. These numbers help statisticians and economists understand the overall health of the economy.

Inflation vs. Deflation

Inflation is caused by a few reasons. These are the two prevalent factors:

Demand-pull inflation

Demand-pull inflation is when the demand for something is stronger than the supply. So, for example, Apple can charge increasingly higher prices for their phones because they’re increasingly popular.

Cost-push inflation

Cost-push inflation is when there’s a high demand for a product or service, but there’s a restriction on supply. This type of situation could be seen when wildfires in California resulted in vastly inflated prices for air filters being sold online.

Negative inflation—or deflation—occurs when the supply of goods or services is higher than the demand for those goods or services. This generally happens because the consumer base has less money or credit than they previously had. A great example of deflation is the Great Depression, during which the cost of goods fell because people did not have access to money or credit due to unemployment, natural disaster, and the stock market crash.

Inflation Throughout United States History

The United States has gone through booms and busts, leading to periods of both prosperity and recession. In order to better understand the trajectory of the rising cost of living and prices of goods, it is important to study historical inflation rates in America.

The Great Depression

The Great Depression of the 1930s occurred because of a range of factors, including wild speculation and liberal lending that led to a bubble burst in 1929, when the stock market crashed. The unemployment rate and natural disaster also played a part.

Economist and Chairman of the Fed Ben Bernanke later theorized that deflation during the Great Depression led to a reduction in value of people’s assets. Since people used those assets for collateral, the banks were faced with greater risk and therefore foreclosed on the loans. In Bernanke’s view, deflation results in a block in the cycle of lending and borrowing that is essential for moving the economy forward.

The 1970s

Although the Fed can increase the strength of the economy by printing money, that comes at the cost of a higher rate of inflation. Higher inflation causes interest rates to rise again and the economy to slow. If the Fed is not careful, its actions can backfire and lead to an economy with high rates of inflation but not very high GDP growth.

In the 1970s, the United States experienced precisely that outcome. Inflation rose throughout the 1970s while economic growth slowed. That experience left a mark on many Americans—so much so that there are people who believe that trying to increase GDP by printing money is so dangerous that it borders on evil.

The Great Recession

While printing money is a way for the Fed to help the economy, if the economy enters a liquidity trap, printing money will no longer be effective. A liquidity trap is when there’s a lot of cash out there, but it’s not being used for spending or investing. Instead, people and institutions “hoard” their money. This is a problem because that hoarded money isn’t boosting the economy and creating jobs by being in circulation.

When the Great Recession began in the United States in December 2017, Ben Bernanke, the Chairman of the Federal Reserve, was aware that there was only a very small chance that he would be able to turn around the United States economy before it hit a liquidity trap. Bernanke responded by printing money aggressively. Economists and other commentators became frightened that he would cause extreme inflation. However, because they were in a liquidity trap, most of the money sat in banks and did not circulate in the wider economy. There were huge increase in the money supply, but only a very small increase in prices.

While the Great Recession was the worst economic downturn since the Great Depression, within several years (and after the Fed lowered interest rates and the government created an 800-million-dollar stimulus package), the economy was able to reach stability.

Inflation Calculator

Curious how inflation has grown in your lifetime, or before? Use this inflation calculator to calculate inflation for any year between 1800 and 2017.

Paul Krugman

Teaches Economics: Think like an economist

For Nobel Prize-winning economist Paul Krugman, economics is not a set of answers, it’s a way of understanding the world. In his MasterClass, Paul teaches you the economic principles that shape political and social issues—like access to health care, the tax debate, globalization, and political polarization. Heighten your ability to read between the lines and decipher the underlying economics at play.

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