A Visual Guide to Inflation

From the folks at Mint.com and WallStats.com VISUAL GUIDE INFLATION Inflation. It can be complicated Let's start with a definition. in fla tion (in-'flā-shən), n. 1. a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency. So basically, it's when stuff costs more. But it can't be that simple right? What about.. THE HORROR OF INFLATION IT WILL EAT YOUR INVESTMENTS! Well inflation is often villified, but it's more complicated than that. Let's start with how it is measured. The government has a shopping list of 80,000 items and services. It collects data on the prices of these items every month. It then averages and weighs these prices using various formulas. The result is a number called the Consumer Price Index (CPI). So when the CPI goes up, then we have inflation? The CPI is a measurement of how much stuff costs us. Currently it is 212. That is generally the case, although there are other indices being measured as well. So inflation is bad right? I mean, I don't want to pay more for stuff. Inflation can be bad, but it depends on your situation. If inflation is 3% and you have... .$100 under the mattress, after one year it will be worth $97. Inflation is very bad. .$100 in an investment with a 4% return, after one year it will be worth $101. The real rate of return is only 1%. Interest What you think you get What you get What inflation gets Inflation is bad, but manageable. .a $100 loan from the bank witha fixed interest rate of 2%, after one year you will owe $102 but it will only be worth $99. Meaning inflation paid $1 of your debt. $100 before inflation $97 after inflation Inflation is good. Ok, so if I owe money, inflation works to my advantage, but too much inflation can't be good right? That's right. You will still feel the effects of unanticipated or excessive inflation. Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run. Lenders are less likely to make loans if they cannot accurately adjust rates to make up for inflation. Those with pensions or fixed income see a decline in their purchasing power and, consequently, their standard of living. When prices are con- stantly changing, energy and money is diverted to keeping prices updated, which creates inefficiencies. If the inflation rate is greater than that of other countries, domestic products become less competitive. What if inflation People hoard tangible items as a way to shed excess cash before it is devalued. This gets really bad? creates shortages of the hoarded items. Hyperinflation can occur when a currency loses its value so rapidly that the very concept of currency becomes meaning- less, such as the issuing of 'trillion dollar bills. The complete breakdown of the economy is often the result. Well a modest amount of inflation is Wow! So we must stamp out inflation at all costs right? often a sign of a growing economy. To avoid inflation investors often convert assets from money to capi- tal projects, creating more growth. So there is a sweet spot? That's right. The Rate of Inflation Toolittle sweet spot Too much High unemployment High prices Liquidity trap Hoarding Risk of deflation Hyperinflation- Stable, predictable economy Ok, I get it. Inflation is not inherently bad. But how do we get inflation? What causes it? This is where economists disagree, as there are several ways that inflation can occur. The economy is good. Companies employ more people. Who make more To meet the demand for money and buy more stuff. more stuff, companies employ more people. Eventually. The price of stuff goes up. The demand for stuff will out- pace the capacity to produce it. This is called Demand-Pull inflation. There is a substantial Such as a disruption in the oil supply. increase in the cost of a good or service. The price of oil goes up. The price of goods and services that rely on oil goes up. This is called Cost-Push inflation. 3. Due to inflation in the past, people now expect inflation to occur. Workers push for higher wages to offset the expected inflation. Employers pass on the higher wage costs to the consumer. The price of stuff goes up and inflation occurs. This is called Built-in inflation. Demand-Pull, Cost-Push, and Built-in form the three sides of the triangle model of inflation. Add them up and you have current inflation rate. But what about the money supply; doesn't that affect inflation? This is the Monetarists' view of inflation who believe the most significant factor influencing inflation is the money supply. When the government prints money or relaxes credit, this is a form of Demand-Pull, but generally happens in a bad economy. The government needs to pay for stuff it can't afford. Prints extra money. More money in circulation. The value of money goes down. Prices are raised to compensate. Inflation happens. Ok, so if inflation gets out of hand, what can be done? Controlling inflation lies mostly with the Federal Reserve who set the federal funds lending rate. It is a delicate balance between keeping the economy moving and keeping inflation in check. The Fed can spur off the economy but also risks inflation. Slowing Economy Higher inflation Lower interest rate Federal Reserve Growing economy Lower inflation Or the Fed can stave off inflation but risks slowing the economy. Slowing Economy Higher inflation Higher interest rate Federal Growing economy Reserve Lower inflation But they generally try to keep it balanced. Slowing Economy Higher inflation Modest rates Modest rates Federal Growing economy Reserve Lower inflation What about the gold standard I keep hearing about? There are several ways to combat inflation, including fixed exchange rates, the gold standard, and wage and price controls, but none of those are used in the US. Ok, so let's recap Inflation is when the price of stuff goes up. But that's not always bad. A little inflation is good, but too much or to0 little and we're in trouble. The main causes of inflation relate to the demand and costs of goods and services. And the Federal reserve can affect inflation by raising or lowering interest rates. You got it. Sweet! So what's deflation? We'll let you know next week in our visual guide to deflation. It's strange stuff indeed. mint.com/blog WallStats.com