Inflation refers to the general rise in prices of goods and services in an economy. When we hear about high inflation rates in the news, it sounds alarming, and as consumers we often wince at just the mention of inflation because we immediately think that we will be in dire financial straits.
Our minds quickly jump to thoughts about what the government is doing to ease inflation and how we are going to continue putting food on the table and providing our families with their daily needs. That's understandable for anybody, especially those living on the margins. But, once we understand some fundamental concepts about inflation, I don't think we'll find it as scary as we make it out to be.
In any economy, a certain level of inflation is reasonable, desirable even. Since the standard definition of inflation is an increase in prices for the stuff that we consume, that should mean that, assuming all things constant, those who provide the goods and services we consume will benefit from the rise in prices.
Furthermore, everyone involved in the production of goods and rendering of services would also partake in this benefit. At least, that's how it should work theoretically. Of course, there are many other external economic factors that come into play which don't always lead to an economic benefit for all just due to inflation.
This article from NPR looks into six different questions that people are curious about with regard to inflation, but were afraid to ask. We'll take a look at some of them here.
The first is whether companies try to make more profits out of inflation. Again, in theory, higher prices in goods and services should naturally lead to higher revenues and incomes. But we also have to consider that the producution of these goods and services aren't free.
Firms adjust the prices of their goods and services based on the costs they incurred during production. There may be instances when firms take advantage of that and pass on the burden of bearing these costs to consumers and raise prices to excess.
Generally, pricing goods and services is a careful balancing act. Unless a firm is a monopoly, they cannot increase their prices beyond what the market can bear or more than their competitors. Otherwise, consumers will simply flock to a competitor who provides the same type of good or service but at a lower price.
If costs of raw materials and labor start to ease, then firms won't have as much pressure to increase their prices. Furthermore, when consumers push back on sudden or extraordinary price increases, firms won't be able to aggressively raise their prices as much.
The second question deals with high interest rates and how they slow inflation. At the fundamental level, there are two reasons why prices increase, just to make things simpler: an increase in demand or a decrease in supply.
Higher demand means firms will need to produce more goods and services, which creates more jobs and higher wages, thus increasing people's incomes, leading to higher consumer spending. When this happens across different firms and industries, it will lead to inflation.
Increasing interest rates means that consumers will be paying more for loans or mortgage. So, they will have less money to spend elsewhere, thus lowering consumer spending. From another perspective, we can also look at higher interest rates as a means of encouraging more saving or investing than spending.
Putting one's extra cash in the money market might yield higher returns than spending that money on goods and services. Therefore, consumers may opt instead to invest their money in treasury bills, bonds, or notes, or if they have a higher risk appetite, the stock market. Reducing consumer spending this way will help ease inflation.
The last question I want to look into is the idea of a non-zero target inflation rate. Isn't a 0% inflation rate better? It may seem good to have a 0% inflation rate in theory, but as we have mentioned before, for any healthy economy, some level of inflation is good. It's a sign that the economy is alive and kicking. Now, let's look at an example when, instead of inflation, deflation occurs.
Imagine this, you've been working at a car manufacturing plant and each year, the plant produces 100 cars. Then, the next year, the company decides that the cars will be sold at lower prices. The plant still produces the same number of cars. Wages and other expenses are held constant. Consumers will be happy about the reduction in prices, and perhaps demand will increase, but that will also lead to losses for the company, until such a point when they will have to close down the plant because it's no longer sustainable.
It's an extreme example, but it just goes to show that, although lower prices will benefit consumers in the short-term, it doesn't necessarily bode well for the long-term, neither does it benefit a growing economy. So, for example, having a 2% target inflation rate is a good thing to keep the economy stable.
There you go. Those are some questions that people may have about inflation but were afraid to ask. You can check out and read the rest of the list on NPR.
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