Inflation Basics

Inflation 101

Inflation: If you’ve ever noticed that prices sometimes seem to increase on certain items, you have likely encountered it.  Some items, such as computers and televisions, have tended to reduce in price. But other needs, such as rent and tuition, appear to reliably increase every year.  

There are several factors that affect the price of goods, including inflation.  And, there are two main categories noted as being the causes of it:  Demand-Pull and Cost-Push effects.

Two Types of Inflation Causes

Detail on the two types of inflation and their causes will be delved into more fully in another future article on The Founding Project website.  

To address a basic understanding, examples of the two types of causes of inflation:   

•            When technology or invention create more efficient ways of producing items, the cost of that item can reduce.  
•           When more companies compete with each other for your purchase, price reductions can cause all competing companies to do the same.  
•           And, in general, when the supply of an item is abundant and the need is low, the cost tends to decrease.  The reverse is true when the supply of an item is limited and demand is high

Government and Inflation

But, our government also has a hand in affecting the prices of goods and services.  The first thought may be to look at the government-imposed taxes and fees placed on items through regulations and fees.  However, there is another factor involved: fiscal and monetary policy.

Simpler Times and the Free Market 

In a simpler time in the United States, Free Markets largely dictated the prices of goods.  As noted above, the supply of an item and the demand for that item was a major force in determining if companies needed to raise or reduce their prices above their cost to create the item.   An example, when orange trees were affected by a disease and the supply of juice oranges reduced while the demand remained the same, the price of orange juice increased. 

Another scenario is when a manufacturer experiences an increase it its cost to manufacture an item and that increase in cost results in an increase in price.  For example, when a fast food chain increased its hourly wages and also faced higher costs for beef, these increases for the company resulted in an increase in the price of their food offerings.

It is also said that, in robust economic times, people have more cash in their pockets and an increased desire to buy.  During those times, companies might be more likely to increase their prices and their profits.

Outside Forces

But, other factors not controlled by consumers, weather, supply or demand are also involved…the value of money, interest rates and fiscal policy.  

As the United States economic structure became larger and more advanced, government regulation became part of the economic picture.

With the dawn of the U.S. Central Bank, that entity also became part of the picture.  These entities determine fiscal policies (also called economic or monetary policy) that directly affect inflation and the price of good and services.

Defining Inflation

To the average citizen, inflation is experienced in rising prices or noticing that their pay check cannot buy as much as it once did.  Our grandparents speak of the days when gas was 25 cents per gallon, as was milk.  Inflation played a major role in changing those prices to what we experience today.

In economics, inflation is a defined as a sustained increase in the price of goods and services in an economy over a period of time.  Inflation means more money is needed to get the same amount of a good or service.  In other words, the same amount of money will get a lower amount of a good or service. 

In essence, inflation leads to a decline in the value of money or in simple terms, your money won’t buy as much today as it did yesterday. Inflation is bad for the economy because if your income doesn’t increase at the same rate as inflation, your buying power declines. 

Inflation Rate – Measuring Inflation

The U.S. Labor Department measures the overall change in the price of goods by collecting information on the average person’s budget.  They collect data about the average hourly wage person’s purchases of every day items.  

While the Labor Department will measure the cost of fuel, energy and clothing, those items are sometimes not included in the routine reporting of the “Consumer Price Index” (CPI).  Also, rent is included in the CPI, but not the cost of homes.  The CPI is the generally used indicator on the level of inflation in the U.S.  for public reporting purposes. That is, the U.S. Inflation Rate is usually considered to be the reported CPI.

For example, the CPI for 2018 was reported as an 1.9% increase.  That means that $1.00 at the start of 2018 was actually only worth 98.1 cents at the start of 2019.

The U.S. Central Banking System (also called The Federal Reserve or The Fed) uses a slightly different measure for inflation called the “Personal Consumption Expenditures Price Index (PCE). 

The Fed prefers to use this different measure of prices to measure inflation, because they prefer a focus on core prices that do not include the more volatile food and energy/fuel costs.  The PCE also includes bills paid on behalf of consumers, such as government reimbursement of hospital bills.  But, both the CPI and the PCE measure prices at the consumer level.

Effects of Inflation

Over time, inflation increases your cost of living, because your pay check cannot buy as much as it once did.  Said another way, items you need cost more money, which means the value of the U.S. Dollar has decreased.  When your money buys less, your standard of living is gradually reduced over time. 

In a general sense, inflation is also considered to decrease employment. While many will try to hang on to jobs and not consider exploring other options, companies are less likely to grow and can be more likely to decrease their work force to stretch their income farther.

Inflation often reduces the rate of savings, because money is seen as losing its value.  People are more likely to try to buy items before prices increase further and less likely to save money in accounts that offer little incentive in interest rates.   

Similarly, citizens are usually less likely to make any investments in an economic environment with increasing inflation, when the earning rates on the investment may not counter rising inflation.  

During times of rising inflation, unless The Fed (U.S. Federal Reserve or U.S. Central Bank System) intervenes by controlling interest rates, interest rates for loans and mortgages increase and consumers are less interested in buying homes or taking out loans for other purchases.  As might be imagined, this would also have a negative effect on employment.

The Value of Currency and National Economic View

According to the International Monetary Fund (a D.C.-based international organization that brings nations together to work toward global financial stability and encourage international trade), inflation is an important economic statistic.  

Inflation rates are part of the measure to define a country’s economic picture, because it affects the value of money and indicates the overall stability of a country’s economy. 

Inflation and Economic Stability

A stable yearly inflation amount is now seen as being between 2 and 4 percent. A high percentage rate of inflation increases costs and makes a country’s exports less competitive in the global marketplace.  This makes a country’s economy appear unstable.

Besides high inflation rates, large fluctuations in inflation, such as a large increase in prices followed by a quick decrease, are also viewed as a sign of economic trouble.  Fluctuations in inflation can cause decreases in economic growth, reduce consumer spending, decrease investments and increase interest rates, which leads to instability. Any inflation over 10 percent per year is potentially problematic for a country’s economy. 

High or unpredictable inflation rates are regarded as harmful to an overall economy.  They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving.

Creating Fiscal Policy

Today, many economists favor a low and steady rate of inflation. The task of keeping the rate of inflation low and stable is usually given to monetary authorities or central banks in each country around the world.  They use fiscal or monetary policies to help control inflation.

Central Banks, such as the U.S. Federal Reserve in the United States, increase or decrease the interest rate to slow or stop the growth of the money supply to help control inflation. For example, the U.S. Federal Reserve may adjust interest rates higher.  This increase reduces the amount of money in use, because fewer people seek loans. 

Some nations also use other monetary policies to affect the economy.  Increased government spending is a means of injecting money into an economy to fuel growth, but it comes with added government debt that can eventually affect inflation.  

What is the current inflationary rate for the United States? As of February 2019, our inflation rate was 1.5%, which is good according to the International Monetary Fund mentioned above.

Inflation Overview

The subject of inflation is complex in many ways and is only delved into in the most basic sense in this article.  

But, for the average American, inflation is a major factor in their lives and has to be considered in household budgetary decisions.  Because it is an invisible force that consumes paychecks with little warning, inflation is often described in negative terms by consumers.  

For citizens, the view of inflation is simply:  How much can my pay check buy this year as compared to last year.  When prices rise too much or prices rise but paychecks don’t increase, people see a negative effect on their purchasing power and quality of life. That’s the most immediate way inflation affects everyone.

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, consider how much it cost to rent an apartment in New York City in 1970. Now, think of how much it costs today. That difference in price is inflation and it is directly affecting your wallet. 

Chris Watkins ~ Chris is the accountant for The Founding Project and when TFP isn’t keeping her challenged, her accounting practice has her more than busy.  Chris studied accounting at the University of North Texas, Denton, TX and has over 35 years in the accounting field working in various industries with 13 of those years in public accounting.   She lends her accountant’s perspective to this article for TFP’s website.  Look for more from Chris in upcoming articles.

References: 

https://www.investors.com/news/economy/what-is-inflation-what-causes-inflation/        https://www.thebalance.com/what-is-inflation-how-it-s-measured-and-managed-3306170        https://www.thebalance.com/causes-of-inflation-3-real-reasons-for-rising-prices-3306094        https://www.investopedia.com/articles/insights/122016/9-common-effects-inflation.asp        Reference.com        MasterClass.com