Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
Inflation can be contrasted with deflation, which occurs when the purchasing power of money increases and prices decline.
Why is 'Inflation' Today’s Term?
As the value of the U.S. dollar continues to languish near long-term lows and U.S. government spending is expected to increase significantly with the new administration, analysts and economists have been forecasting a rise in inflation on the horizon. Though inflation currently remains tame, as it has been for much of 2020, we’ve recently seen an uptick in consumer inflation as gasoline and other commodity prices have crept higher.
What does it mean for the typical consumer when inflation rises? It simply means that the value of the currency weakens and consequently, the general level of prices for goods and services rises. Most importantly for consumers, commodity prices climb higher, making critical purchases like food and gas significantly more expensive. For investors, generally speaking, a measured increase in inflation can be positive as it can also lift asset prices. Inflation is detrimental for people holding cash, however, as it erodes the value of their cash holdings.
Inflation vs. Deflation
Inflation is a quantitative measure of how quickly the price of goods in an economy is increasing. Inflation is caused when goods and services are in high demand, thus creating a drop in availability. Supplies can decrease for many reasons; a natural disaster can wipe out a food crop, a housing boom can exhaust building supplies, etc. Whatever the reason, consumers are willing to pay more for the items they want, causing manufacturers and service providers to charge more. The most common measure of inflation is the consumer price index (CPI). The CPI is a theoretical basket of goods, including consumer goods and services, medical care and transportation costs. The government tracks the price of the goods and services in the basket to get an understanding of the purchasing power of the U.S. dollar.
Inflation is often seen as a big threat, mostly by people who came of age during the late 1970s, when inflation ran wild. So-called hyperinflations occur when the increase in monthly prices exceeds 50% over some period of time. These periods of rapid price increases are often accompanied by a breakdown in the underlying real economy and may also see a sudden increase in the money supply. While hyperinflations can be scary, they are historically rare. In reality, inflation can be either good or bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation can be quite bad for the economy, as we will see below with deflation. A modest amount of inflation can actually encourage spending and investing, as inflation can slowly erode the buying power of cash—so it is relatively less expensive to buy that $1,000 appliance today than the same $1,000 in a year.
Deflation
Deflation occurs when too many goods are available or when there is not enough money circulating to purchase those goods. As a result, the price of goods and services drops. For instance, if a particular type of car becomes highly popular, other manufacturers start to make a similar vehicle to compete. Soon, car companies have more of that vehicle style than they can sell, so they must drop the price to sell the cars. Companies that find themselves stuck with too much inventory must cut costs, which often leads to layoffs. Unemployed individuals do not have enough money available to purchase items; to coax them into buying, prices get lowered, which continues the trend. (Note that deflation is not the same as disinflation, which is a decline in the positive rate of inflation from period to period).
Deflation can lead to an economic recession or depression, and the central banks usually work to stop deflation as soon as it starts.
When credit providers detect a decrease in prices, they often reduce the amount of credit they offer. This creates a credit crunch where consumers cannot access loans to purchase big-ticket items, leaving companies with overstocked inventory and causing further deflation.
Prolonged periods of deflation can stunt economic growth and increase unemployment. Japan's "Lost Decade" is a recent example of the negative effects of deflation.
Just as out of control hyperinflation is bad, uncontrolled price declines can lead to damaging a deflationary spiral. This situation typically occurs during periods of economic crisis, such as a recession or depression, as economic output slows and demand for investment and consumption dries up. This may lead to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy.
Consumers and businesses alike begin holding on to liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand. At this point, people's expectations regarding future inflation are also lowered and they begin to hoard money. Consumers have less incentive to spend money today when they can reasonably expect that their money will have more purchasing power tomorrow.
