Inflation isn’t what you think it is.
With memes about “just printing more money” or “money machine go brrr," inflation has taken a place in public discourse, no longer relegated to dreary economic conferences.
But what exactly is inflation? How do we measure it? What happens if it’s "too high” or "too low?”
And does it actually matter, or is it just an imaginary topic that eggheads debate about until their tenure runs out?
What is inflation?
Inflation is just how much your money can buy you from one time to the next.
An example of this is car prices. Back in 1955, a Chevrolet four-door sedan would cost you $1,987. Today, your entry-level Chevy Malibu runs you $22,140. Now, over time, it’s not that making a car is so different that the costs have increased $20,153 — it’s that the dollar has lost its power over time.
Why does this happen? Most inflation occurs because of changes in price due to supply and demand.
For example, let’s consider a sneaker market. Assume an average shoe price of $100, and then say Nike drops a new Jordan sneaker. They know the demand for that sneaker is going to be high, so they change the price to $150. Consumers buy the shoe at a higher price because it’s in high demand.
Ten years down the road, other shoemakers raise their prices, as they see people spending more on their products. Now the average price is $120. That would be a 20 percent inflation rate in the sneaker market over 10 years, or two percent per year.
There are two other forms of price increases that lead to inflation. One is when the underlying cost of goods used to make a final item rise, so the final good price must rise. This is very common with items that rely on underlying goods that have high variability in their prices, like food and gas.
The other has to do with wages. When prices increase, wages will increase as employers adjust to the higher cost of living for their employees. This wage increase then gives consumers more money to spend, which pushes prices up again.
How do we measure it?
Every quarter, the U.S. Bureau of Labor Statistics calculates the price of a basket of goods. This basket is composed of everything from food to transportation and energy prices. It’s designed to model what the average consumer buys.
Once this basket price is calculated, it’s then compared to historical data, and an inflation rate is calculated using those numbers.
What does good or bad inflation look like?
But is inflation bad? Not necessarily.
To have a steady growth of inflation is good! This means the economy is consistently expanding. If inflation is too low, we get deflation, and growth stagnates.
If inflation is too high, consumers can’t afford the basic goods, the economy becomes overheated, and a recession is almost guaranteed. Right now, the target for inflation is two percent, and we’ve been slightly below that for a bit.
What to do?
The biggest thing to consider with inflation has to do with your long-term financial positioning. For any investment you make in the long term, you want to assure the rate of return is greater than the expected rate of inflation over that time period.
If you keep your money in a saving account that returns one percent per year, and inflation is two percent each year, you’re losing one percent of your money to inflation each year.
It’s not that money “disappears” from your account — it’s that your money, a year later, can only buy you 99 percent of what it used to.
The other consideration is to make sure your pay keeps up with employment. Many jobs have raises, but those have not been consistent with the change in prices.
The minimum wage and many entry-level jobs have consistently undershot inflation, leading to the weaker purchasing power of those employees. So, when negotiating your contract, make sure to make some points about inflation-tied raises.
Now there’s a whole lot more to be said about inflation, from how fractional reserve banking has accelerated it, and we shouldn't just print money like we’re in the Weimar Republic.
But in the end, it’s just one way to analyze the economy. Just like other indicators, it’s good to keep in mind when making financial decisions — not some edict of investment.
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