What Is Inflation?
Inflation is what happens when prices in a particular country rise so high and so quickly that they upset the nation’s economy. Prices may start rising rapidly because people want to buy more goods than there are goods to go round. Fears of still higher prices may cause people to rush out and buy things while they can still afford them. Thus the demand for goods increases and the cost of them goes up even faster. One cure would be for people to stop buying, but of course, it is difficult to persuade people to stop buying things they want.
Workers whose wages buy them less, old people whose pensions are no longer enough to live on, students whose grants no longer support them, all press for increased money to keep up with prices. Higher wages often mean dearer goods. As a result of inflation, the purchasing power of a unit of currency falls. For example, if the inflation rate is 2%, then a pack of gum that costs $1 in a given year will cost $1.02 the next year. As goods and services require more money to purchase, the implicit value of that money falls.
The Federal Reserve uses core inflation data, which excludes volatile industries such as food and energy prices. External factors can influence prices on these types of goods, which does not necessarily reflect the overall rate of inflation. Removing these industries from inflation data paints a much more accurate picture of the state of inflation.
The Fed’s monetary policy goals include moderate long-term interest rates, price stability and maximum employment, and each of these goals is intended to promote a stable financial environment. The Federal Reserve clearly communicates long-term inflation goals in order to keep a steady long-term rate of inflation, which in turn maintains price stability. Price stability, or a relatively constant level of inflation, allows businesses to plan for the future, since they know what to expect.
It also allows the Fed to promote maximum employment, which is determined by nonmonetary factors that fluctuate over time and are therefore subject to change. For this reason, the Fed doesn’t set a specific goal for maximum employment, and it is largely determined by members’ assessments. Maximum employment does not mean zero unemployment, as at any given time people there is a certain level of volatility as people vacate and start new jobs.
Monetarism theorizes that inflation is related to the money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.
Historical Examples of Inflation and Hyperinflation
Today, few currencies are fully backed by gold or silver. Since most world currencies are fiat money, the money supply could increase rapidly for political reasons, resulting in inflation. The most famous example is the hyperinflation that struck the German Weimar Republic in the early 1920s. The nations that had been victorious in World War I demanded reparations from Germany, which could not be paid in German paper currency, as this was of suspect value due to government borrowing. Germany attempted to print paper notes, buy foreign currency with them, and use that to pay their debts.
This policy led to the rapid devaluation of the German mark, and with it, hyperinflation. German consumers exacerbated the cycle by trying to spend their money as fast as possible, expecting that it would be worth less and less the longer they waited. More and more money flooded the economy, and its value plummeted to the point where people would paper their walls with the practically worthless bills. Similar situations have occurred in Peru in 1990 and Zimbabwe in 2007-2008.
Inflation and the 2008 Global Recession
Central banks have tried to learn from such episodes, using monetary policy tools to keep inflation in check. Since the 2008 financial crisis, the U.S. Federal Reserve has kept interest rates near zero and pursued a bond-buying program – now discontinued – known as quantitative easing. Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight years. There are many, complex reasons why QE didn’t lead to inflation or hyperinflation, though the simplest explanation is that the recession was a strong deflationary environment, and quantitative easing ameliorated its effects.
Inflation in Moderation: Harms and Benefits
While excessive inflation and hyperinflation have negative economic consequences, deflation’s negative consequences for the economy can be just as bad or worse. Consequently, policy makers since the end of the 20th century have attempted to keep inflation steady at 2% per year. The European Central Bank has also pursued aggressive quantitative easing to counter deflation in the Eurozone, and some places have experienced negative interest rates, due to fears that deflation could take hold in the eurozone and lead to economic stagnation. Moreover, countries that are experiencing higher rates of growth can absorb higher rates of inflation. India’s target is around 4%, Brazil’s 4.5%.