Economy Explained: What Is Inflation and What Does It Mean When It Goes Up or Down?
In 1970, a cup of coffee cost around 25 cents. Today, that 25-cent cup of joe would actually cost around $1.70. The coffee didn’t get any better. The price was driven up by the relentless pressure of inflation, which nibbles away at the purchasing power of currency while causing prices to rise over time. If you feel like a buck doesn’t go as far as it used to, it’s not your imagination. It’s inflation.
Inflation Happens When Things Are Good
No one likes to pay more for the same tank of gas, haircut or previously mentioned cup of coffee, but inflation is actually a good thing — at least when it’s slow, steady and predictable. When the economy expands, wage earners have more money to buy things. That increases demand, which causes prices to rise. When prices rise, wages follow suit and the standard of living increases.
There are three kinds of inflation:
- Demand-pull: Prices rise when demand for goods or services exceeds the supply
- Cost-push: When increased production costs force prices up
- Built-in: When wage increases follow price increases
Also, governments cause inflation when they print money to pay for spending.
The CPI Is Like an Inflation Tape Measure
Economists use several indices to track inflation, but the most widely cited and widely followed is the Consumer Price Index (CPI). The CPI tracks inflation by measuring the average change in the cost of a given basket of common consumer goods and services over time.
Too Much Inflation Is Never a Good Thing
In 2009, Zimbabwe printed its first 100 trillion dollar bill (in Zimbabwean dollars), worth about $300 in U.S. money. A type of intense runaway inflation called hyperinflation had sent the country’s currency into freefall. The price of bread rose to 300 billion Zimbabwean dollars and, like all commodities, increased every day as inflation hit 231 million percent.
Although drastic hyperinflation like this is rare, and hyperinflation, in general, is rare in industrialized nations, inflation can become worrisome long before a few billion bucks turns into pocket change. Anyone who endured the Great Inflation of the 1970s can attest to how quickly the currency-killing phenomenon can spiral out of control, even in wealthy Western countries.
Then Again, Neither Is Too Little
Too much inflation causes mass unemployment and depressed wages, which throws cold water on any and all economic growth. Too little inflation, however, can have the same effect. When inflation is very low, it means demand for goods and services is low, which means the economy is constricting and heading toward recession.
When inflation goes negative and prices fall, it’s called deflation. That might seem good for cash-strapped consumers but it’s death for national economies. When prices fall, people stop paying for goods and services — why shouldn’t they if those things will probably be cheaper in a few weeks? Here, too, the end result is recession.
The Sweet Spot Is Somewhere in the Middle
In review, a little inflation is healthy, but too much:
- Stops economic expansion
- Depresses wages
- Causes unemployment
- Indicates recession
- Forces governments and central banks to take drastic and risky actions like printing money, manipulating interest rates and artificially inflating wages
Too little inflation, on the other hand:
- Does the exact same things
Walking this economic tightrope is a delicate balancing act — so how much inflation is just enough? According to the Federal Reserve and many top economists, the sweet spot is around 2%. At that rate, wages can rise enough to keep up with price increases, the economy can grow and inflation can do to you what it does to everyone — turn you into an old person who bores children with stories about how Netflix used to cost $10 a month until they finally get you to turn over $50 for an ice cream cone.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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