A part-time college economics & finance instructor who began his career in banking, Chuck frequently writes on money & economics online.
What is Inflation?
June 28, 2011
Inflation is never good for a nation. Inflation causes prices to rise on all goods and services in the economy which makes it more expensive for people to buy things.
From the perspective of an individual, inflation is no different than a pay cut in that, with inflation, the money that one receives in their paycheck buys less than it did before.
In fact, since inflation, once it gets going, tends to keep increasing the effect is more like a reduction in pay each pay day in that each paycheck buys fewer and fewer goods.
Economists use the terms nominal income and real income to differentiate between the dollars (or other unit of currency) one receives in their paychecks and the value of the goods those dollars will actually buy.
Nominal income refers to the actual number of dollars one received as their pay. This figure is generally constant for most people as those on a salary are paid a fixed amount each payday while those paid on an hourly or commission basis will tend to receive the same dollar amount of pay as their hours worked or sales generally remain somewhat constant.
Real income is a person’s nominal income adjusted for inflation (or deflation). This is what the dollars in a paycheck will actually buy. With inflation those relatively constant dollars received each pay day will buy less and less as the prices of goods and services keep rising.
Looked at it this way, as a cut in people’s pay, inflation is not good.
What is Inflation?
Before going further let me define what inflation is and what causes inflation to occur.
There are actually two definitions of inflation.
The first is the classical definition which is basically an increase in prices throughout the economy resulting from an increase in the money supply, or amount of money in circulation, by the government.
The second is favored by politicians and Keynesian economists and that is any increase in overall prices (the price level) in the economy.
This second definition is broader and encompasses both inflation resulting from an unneeded increase in the money supply as well as increases in prices due to a price increase in a product that is used in the production of many other goods in the economy.
Inflation Resulting From an Increase in the Money Supply
Historically, inflation has usually resulted from governments either debasing metallic (gold or silver) coins by mixing the gold or silver with a cheaper base metal or by printing paper money in large quantities. Today, most nations increase the money supply by having their government controlled central bank inject additional reserves into the banking system.
This has the effect of enabling the banks to make more loans thereby increasing the amount of money in circulation.
Any way inflation is accomplished, the result of creating more money, metal, paper or electronic, than the amount of existing goods in society produces inflation.
Continuing to create money in this manner results in increasing the inflation rate and, if continued long enough the increasing rate of inflation will lead to hyper inflation, a situation where money is worth less than the paper it is printed on.
Inflation Resulting from an Increasing Price Level
Economists use the term price level to describe the overall level of prices in an economy. A rising price level means that prices of all or most goods and services are increasing. A falling price level means that prices in general are decreasing.
While increasing the money supply will result in a rising price level, other things can also cause this.
Demand Pull Inflation
Demand Pull Inflation is a term, usually associated with Keynesian economics, that is used to describe a rise in the price level resulting from an increase in aggregate demand. Aggregate demand refers to total demand for all goods and services in the economy.
This increase in the price level caused by an increase in aggregate demand can be caused by a number of things which include:
- an increase in the money supply which provides consumers, business and government more money to spend and this increase in spending causes an increase in aggregate demand.
- an increase in spending by consumers, business or government as a result of growth induced rising incomes and/or easier access to credit.
- an increase in exports where by foreigners begin purchasing larger quantities of the economy’s output thereby reducing the domestic aggregate supply.
So long as there are unemployed resources (resources being land, labor, capital and entrepreneurship) the increase in aggregate demand will be met with an increase in output and incomes (real Gross Domestic Product or GDP) which will moderate the price increases.
However, when resources are fully employed, further increases in aggregate demand will result in rapidly rising prices. Left alone, the economy will readjust as the rising prices cause increasing numbers of domestic and foreign consumers to cut back on purchases thereby slowing the rate of growth and decreasing aggregate demand. Also, as costs and interest rates rise, producers will start reducing their purchasing and expansion activities.
In the long run, increased investment in labor saving equipment will enable workers to be more productive as will advances in technology and more efficient production processes.
Outsourcing of labor intensive production to areas with a labor surplus as well as increased immigration will reduce labor shortages (increased births will also do this, although it takes about 20 years before newborns enter the labor force).
Cost Push Inflation
Cost Push Inflation is another term associated with Keynesian economics which refers to the price level rising due to the increase in one or more critical resources. The resources in question are usually rising labor costs across the economy or rapidly rising costs for a natural resource such as oil or food.
Strong economic growth will often result in a reduction in the supply of labor as growing demand for workers by employers seeking workers as they increase their output.
Other factors that can reduce the supply of labor, thereby driving up wages overall, can be unions which act, usually with the backing of government, as cartels to artificially limit the supply of labor.
War may also reduce the supply of labor as the government, either voluntarily or through conscription, mobilizes much of the available manpower for military duty. This reduction may be short term if the war is short and casualties light or long term in the case of a long war and/or heavy casualties.
While not common today, plagues, such as the Black Plague during the Middle Ages, have resulted in a big reduction in the supply of labor causing wages to rise.
The supply of other critical resources such as oil or food can also be reduced due to war, natural disasters or the formation of cartels (think OPEC) can cause a reduction in the supply of and the increase in prices of these resources to occur.
Oil is especially critical in today’s world as it is a main energy source used in all phases of production. As the price of oil increases, producers throughout the supply chain find themselves paying more for both oil for energy as well as more for other inputs that consumed energy in their production.
These increased prices are passed on during each stage of production resulting in rising prices throughout the economy.
Like most instances of demand pull inflation, the cause of cost push inflation is the market’s response to shortages. And, just as the market, if left to itself, will adjust to these changes and work itself out in the case of demand pull inflation it will also work itself out in the case of cost push inflation.
Unfortunately, government policies are often not only responsible for the cause of the cost push inflation, they also often make the problem worse by attempting to ease the problem by increasing the money supply in an attempt to off set the price rises.
Moral Problems with Inflation
Inflation is both an economic problem and a moral evil.
While inflation is never good for the economy as a whole, it can, in its early stages at least, benefit certain groups within the economy. This benefit for certain groups however, comes at the expense of others in the economy.
Like theft, which is what inflation is really all about, in which the thief gains wealth but at the expense of the victim, inflation also transfers wealth from one group to another.
Some examples of this wealth transfer are:
- Self employed Professionals can often increase their incomes to keep up or stay ahead of inflation thereby gaining or at least not suffering from inflation in its initial stages.
- Regular employees whose wages are fixed by their employer or by union contracts that fix wages for a year or more. In the past unionized workers whose hard won union contract guaranteed them a good wage often saw the value of that wage shrink as inflation set in.
- Borrowers gain because they are able to repay their loans with money that is worth less than the money they borrowed.
- Lenders are hurt as the value of their loans are being repaid with cheap money whose purchasing power is less than the purchasing power of the money originally loaned.
While many people look upon this as the poor little guy or common man vs the the wealthy bank, the truth is that the money the bank has to lend comes from similar poor little savers who have been salting part of their earnings away for retirement, a vacation, a new home, an emergency, etc in their bank accounts.
The wealth transfer here is from the average citizen who saves to the average citizen who borrows. Normally, there is nothing wrong with being a borrower or saver as each benefits from the actions of the other.
However, inflation perverts this normally mutually beneficial relationship into a form of theft.
- A big beneficiary, again in the early stages of inflation, is politicians and government. Since ancient times unscrupulous rulers have used inflation to advance government wealth at the expense of their people.
Governments and politicians often see inflating the money supply as a way to increase spending without having to raise taxes.
The effect of inflation on people’s incomes is the same as taxes as it reduces their spending power the same as taking the money directly in the form of taxes. It is the same for the government as well as it has more money to spend.
The big difference is that inflation does this by stealth rather than directly as with taxes, thus making it more difficult for voters to associate their decline in income with the officials at election time.
Political & Economic Problems With Inflation - Hyperinflation
In addition to the economic and moral problems described above there is the danger that inflation will continue to expand until it becomes a deadly hyperinflation.
With hyperinflation, paper money is less than worthless with the paper the money is printed on having more value that the monetary value printed on it.
With hyperinflation, not only does the economy and normal commercial transactions break down but society and the government also often fall.
While there have been a number of instances of hyperinflation in recent centuries, the classic case of ruinous hyperinflation is the German Wiemar Republic that was established to govern Germany following World War I and the abdication of Kaiser Wilhelm II.
In the aftermath of the war Germany was broke and its economy in shambles. The new government attempted to solve its financial problems by printing money which led to inflation. The printing continued and soon the country was in the midst of a severe hyperinflation.
The situation was so bad that it literally took bags of high denomination bills to purchase every day goods. The bills themselves were usually worthless shortly after they were printed and there are photos from that era showing people burning notes in stoves to heat their homes as the paper notes were more valuable as fuel than as money.
Other photos depict people using large denomination bills to paper their walls or to use as note paper to write on. Again, it was less expensive to use the money itself for these things than to attempt to purchase things like firewood, wall paper, note paper, etc.
Most historians today cite the economic and political destruction in Germany caused by the hyperinflation as a major reason for the coming to power of Adolph Hitler and his Nazis.
People Acting to Protect Themselves Against Inflation
Interestingly, following World War II, Germany, with its people having bitter memories of the past hyperinflation, pursued sound money policies and avoided many of the Keynesian policies, which favored a certain amount of inflation, that the United States and other Western European nations followed.
As a result, Germany did not suffer the serious inflation (which fortunately did not reach hyperinflation proportions) that the United States and most West European nations endured in the decades following World War II.
With their bitter memories of their sufferings during the hyperinflation during the Weimar Republic years, the German people were quick to react to any hint of pending inflation by taking steps to protect themselves economically in the market and by threatening action against sitting politicians at the polls.
Being a form of theft based upon deceit, inflation only works for governments when they can make people believe the inflated money they are producing is real. Once people are on to this and take protective action, such as moving to gold or so called hard currencies (which are currencies of other nations whose currencies are not inflated), etc.
While such actions will not stop an out of control hyperinflation once it starts, the threat of such actions will prevent rulers from benefiting from starting to inflate their currency and, by not being able to use inflation to solve a short term problem, rulers will be less likely to turn to inflationary policies as a solution to problems the government is facing.
© 2011 Chuck Nugent
JON EWALL from usa on August 01, 2011:
''the government) is spending money''
CHECK OUT THE FOLLOWING
Senator Coburn commented on the house cap, cut and balance bill submitted to the Senate. The Senator made a presentation of all the waste in our government pointing out that the house bill if allowed to debate on the Senate floor could have been the solution to the debt crisis.
See COBURN REPORT
WASTE IN the US GOVERNMENT
Phil Plasma from Montreal, Quebec on August 01, 2011:
I like the idea that my inflated dollars of lesser value are paying the mortgage, however, if my salary is also being eaten up by inflation, I don't have any extra money for this really to mean anything.
plusones from UK on July 23, 2011:
At least it makes us step back and look at the way people (mainly the government) is spending money and how things can be prevented in the future
htodd from United States on July 15, 2011:
Thanks for the great post ..nice
About Forklift Training on July 14, 2011:
Fantastic article! Great analysis of inflation and it's cost to a nation. Voted up!
munirahmadmughal on July 14, 2011:
The hub is rich in content and covering all angels of the problem critically. This is the problem and has been well diagnosed. What is the solution and who are to offer it?
Problems arise and problems are created. It is the motive behind the actions with which acts are to be adjudged. When a problem is the problem of all, all have to play their role to solve it in a manner that the root cause is removed. Good governance comes by honest performance by each one of us. Now is the era of science and information technology and legitimate, correct and proper data can be collected to control any problem. It is the falsehood that causes all problem in the solution of a problem. Mutual cooperation can facilitate the solution. Vested interests perpetuate the problem.
The hub is excellent and up by all standards.
JON EWALL from usa on July 13, 2011:
Just a note! The 2011 federal budget hit a $1.85 trillion deficit with 3 more months to go.Obama proposed a 2012 budget that had a $2.4 trillion deficit. the Senate voted it down 94-0.TODAY Congress and the President are debating to raise the national debt limits.
It's insane to believe that they will agree.
sreekumar sukumaran on July 13, 2011:
Inflation is a short term measure for states to overcome financial problems but a long term chance for individual investors. Stay invested in Gold and Real estate to escape the crisis.
SUSIE DUZY from Delray Beach, Florida on July 13, 2011:
All I know is that the cost of living keeps going up and my income is not.
WesternHistory from California on July 13, 2011:
Very good hub. Inflation can affect people in different ways and depending on your individual financial situation inflation can be good or bad. For the people not able to invest such as in housing or even sometimes stocks, inflation can be devastating. If your entire paycheck goes to fuel costs, utility bills and food, inflation can be crippling. That seems to be the case for most people but not all.
If on the other hand you are an investor and manage to purchase real estate in this down market, you can be rewarded with large gains when the housing market recovers, whenever that may happen. Same with stocks with the exception that some stocks will be hurt by inflation.
While inflation is generally not a good thing and it adversely affects working families with not a lot of resources, it can be a positive for a minority. Regardless,it n eeds to be controlled as much as possible since runaway inflation is a negative for a country overall.
John Coviello from New Jersey on July 13, 2011:
A 100 Score on a Hub! I never saw that before. Congrats Chuck!
We can all agree that both runaway inflation and deflation are generally bad things for an economy and the people living in the economy. But low inflation is part of a growing economy. In fact it is an indication that an economy is growing, as there is competition for good, labor, and services. Low inflation makes fence sitters buy houses and cars, as they don't want to pay more next year. Of course, pay increases need to keep up with inflation to not lose buying power.
The problem in the U.S. is that we can not trust the federal government's inflation figures. They are highly skewed towards the price of housing (which has been falling in recent years as other prices rise). They do not accurately measure the true inflation rate in the U.S. This skewing of the true inflation rate helps the federal government by lessening or eliminating cost of living increases in Social Security and other programs. Many economists have pointed out that if inflation today was measured the way it was 30 years ago, the official U.S. inflation rate would be much higher than the headline number that is released each month.
Mansi2512 from Bangalore,India on July 13, 2011:
I would just say that inflation has created a kind of bad life for the people. It did not affect me much because Im a student. But for my father it did. During the period of inflation there wasnt a rise in the prices and many eligible students were denied good jobs. The economy of the countries went hay-wire. A few points that you pointed out were true but then we must think of people of all countries and ages. It did affect very harshly I would say.
jayb23 from India on July 12, 2011:
Awesome hub Chuck. Liked the analogy on pay cut. I agree inflation is not good for any economy, we here in India are facing massive inflation, cost of living has become high. But I will also add the deflation is also not good. Look at Japan. Keep up the good work. Voted up.
Felix J Hernandez from All over the USA on July 11, 2011:
No. But what choices are left to balance when dollars are not back by gold.
Greg Sage from Orlando, Florida on July 11, 2011:
Calling what's happening with the housing market "deflation" so that it sounds like the opposite of "inflation" is just misdirection. It doesn't actually say anything about inflation. Well, if the opposite of inflation is bad, then....
The fact that a house sells for less is not the same thing as economic deflation. After all, the dollars the seller receives for it aren't worth more. In fact, they're worth less since he receives fewer dollars.
They're two different things that rhyme the way people say them. The housing situation and the fed printing more money are no more opposites than a "boat" and a "goat."
One might argue, however, that they both have roots in the federal government's intervention policies that were sold to the public as ways to help the poor. Whether it was forcing Fannie Mae to drop credit requirements to nonsensical levels to help marginal buyers, or tying entitlement programs to inflation rates in a positive feedback loop, or just printing more money to avoid the short-term repercussions of unsound policies.
John Coviello from New Jersey on July 11, 2011:
Inflation is not all bad though. I know runaway inflation is very bad. But look at the housing market. It suffers from deflation, not inflation. Mainly because loose credit policies last decade raise the price of housing to much higher levels than it would have gone to otherwise.
An interesting article would be about how the government's calculation of inflation has changed over the decades. I've heard that if they were using the inflation formula from 30 years ago today, that we'd have much higher inflation numbers. In other words, the government has found a way to cook the inflation books, and the actual inflation rate is much higher than the headline number.
JON EWALL from usa on July 10, 2011:
Rising cost of food, gasoline and other necessities are a form of inflation. It takes more of your money to purchase the necessities of life. Devaluation of the dollar is another form of inflation.
Eric Coggins on July 10, 2011:
This hub is very well-written and extremely informative. I learned much from reading it.
Greg Sage from Orlando, Florida on July 10, 2011:
"Pay increases" tied to inflation are a fallacy on multiple levels.
The fact that we have politicians who attempt to do things like tie minimum wage and other factors to inflation only shows a profound ignorance of the positive feedback loop these things create.
Anyone who has even a basic knowledge of thermostats knows you don't rig it so it blows MORE heat every time it gets too hot.
Tying inflation CAUSING factors to the inflation rate is no different. The problem is that it takes more than a 5 second soundbite to understand WHY some of these things are fundamentally unsound.
Which is why the only real long-term (multi-generational) solution is (as it is with many things) in improving education.
WITHOUT education, people just say things like "It's ok, we'll just raise the minimum wage, social security payments and so on to match."
Chuck Nugent (author) from Tucson, Arizona on July 09, 2011:
Rock_nj - you are correct in pointing out that inflation can help consumers and others payoff debt.
However, there is a branch of economics known as Rational Expectations that holds that people learn from experience and react to changes like inflation. Lenders (a group that includes people who have bank savings accounts) see inflation and react by moving to adjustable rate loans which compensate them for losses due to inflation.
Adjustable rate mortgage loans are not that common now but they are in place and lenders will be pushing them if inflation begins to heat up. Credit cards and many other types of consumer and commercial debt already have adjustable features built into them.
One of the bright spots on the inflation horizon is that practically everyone alive in the U.S. and many other nations today either has memories of the major inflation of a little over a quarter century ago or has parents and grandparents who are more than willing to tell them about the bad old day of inflation. With collective inflation memories of inflation still vivid in many minds people will react quickly to any uptick in inflation thereby negating advantages to governments and groups that may benefit from it.
As evidence of this just look at the huge trading in gold, an inflation hedge, and the huge influx of individual traders in the currency markets. FOREX trading is open to anyone with a few dollars to speculate with. It is not just speculators but small businesses and individuals seeking to protect their assets by shifting into other stronger currencies when their government begins to inflate their national currency.
Inflation works best (for governments) when they are able to inflate their currencies without people being aware of it. However, today as soon as the smallest scrap of evidence of inflation is detected it is quickly broadcast widely and significant numbers of people begin reacting quickly to protect themselves.
So I wouldn't count on inflation coming to the rescue of governments and individuals looking to pay off their debts easily.
Thanks again for your comments.
John Coviello from New Jersey on July 09, 2011:
The one thing that inflation can be good for is consumer debt. Let's say your 30-year mortgage payment in 2010 is $1,000. At 2 or 3% inflation and cost of living adjustments of similiar amounts at work, you will not be able to reduce your mortgage payments as a percentage of income in a significant way. But with a higher inflation rate and higher pay increases from your job, you could reduce your mortgage payment as a percentage of income in a significant way.
People are right to point out that consumers will be hit with inflation pressures elsewhere. But at least there are alternatives for dealing with that, such as switching to cheaper alternative brands. Your mortgage payment is what it is.
This is exactly the mentality of The Fed when they encourage inflation to inflate away the national debt.
AgesMGMT from New York on July 07, 2011:
yeah but even the pay increase that people have mentioned is a false increase. One benefit that by no means overshadows the negative effects of inflation is that it cause consumers to spend more money because they fear that their savings will not be worth as much. This in turn can stimulate the economy.
JON EWALL from usa on July 05, 2011:
‘’Inflation is both an economic problem and a moral evil.’’
Take note that 20% of home mortgages are under water. The value of one’s investment in the housing industry has lost in some places 25% of the valued investment. The politicians are not talking on how one can recoup their loses.
Inflation is in the near future, one can’t imagine how citizens on fixed incomes will survive when their savings become reduced by inflation.
We have an incompetent bunch in Washington who have no idea on how to solve the problems.
Pintoman on July 04, 2011:
Excellent article. Voted up and an awesome.
phartten on July 02, 2011:
The one thing that inflation does is create pay increases and if you have a fixed mortgage rate...you will pay down your debt with inflated dollars.
That is why the Fed/Govt. will inflate up ahead...to get the debt paid some how. Wait and see. Buy things that go up in value when inflation hits...gold/ silver/commodities.
Avoid new cars that depreciate...eventhough you wan the new model.....since they all look almost identical now.....even the new models are only slightly different....so get a 3 year old and buy things that will go up in value or be sad down the road.....really sad.
Read about inflation in Zimbabwee.....German in 1945.....South american countries....massive inflation in our lifetimes. It is coming as we are over the cliff now in this country. 14 tillion.....4 trillion added on since Obama came in office.....it was 5 tril...then 10 trill and soon 15 tril...and in 10 years...upwards and on over.....
Be carefullll..... inflation is coming and it will be severe.
Steven Huffer from Irving, Texas on June 30, 2011:
Paying more in the short term could result in a more stable economy down the road.
Carolee Samuda from Jamaica on June 29, 2011:
The worse thing about inflation is that there is no increase in wages/salaries, as you mentioned your paycheck is like a reduction where it can only purchase less.
Inflation not only affects tangible goods, it also affects lifestyle, utilities and the future purchasing power.
Sinea Pies from Northeastern United States on June 29, 2011:
Wonderful hub. The pay-cut analogy makes it so clear. Voted up!
Paradise7 from Upstate New York on June 29, 2011:
Great hub, though a lot of this info was familiar to me. Though we can all see the handwriting on the wall, what to do about it now? Any ideas on solutions?
ocbill from hopefully somewhere peaceful and nice on June 29, 2011:
I am livid that Bernanke and Obama are continuing this charade. A friend told me to get into hard assets as well. Jim Rogers says the same. Then you look at home financing barriers getting even tougher. The writing is no longer on the wall, it is in the sky too. Very good hub and share
Randall Kaiden from Oxnard & Santa Clarita, CA on June 28, 2011:
The US government is on thin ice economically. Everything above is true but if the government doesn't inflate, it's difficult to see how it can manage to pay all it's debts and obligations. If the US government were a company it would probably be seeking bankruptcy protection because it's income doesn't meet it's expenses. To inflate or not to inflate, either way things are not looking good. But on the other hand, maybe the US will somehow muddle through. We can only hope...
Greg Sage from Orlando, Florida on June 28, 2011:
I think this outlines fairly well why policies carried out in the name of helping the poor that end up causing inflation are, in fact placing what is essentially the cruelest tax of all upon everyone in the process.
Those whose subsistence consumes most of their resources suffer the most. The value of one's stock portfolio taking a hit is not the same as one's last dollar no longer being enough to purchase food.
The use of inflation-producing policies to mask unsound economic principles is one of the great lies told by governments.
Better education of the voting public is the only long-term solution.