For my first real post here, I’d like to dive right in to an important financial issue with important ramifications for millions of ordinary citizens. That issue is the inflation rate. In this first installment of the series, I’d like to talk about what inflation is and what causes it. In the next installment, I’ll discuss how the federal government measures inflation and attempts to control it. Then, in the final installment, I will summarize some interesting conclusions in a report by Unison Investment Management about how the government’s decisions about how to measure and combat inflation have led to a decrease in home ownership rates and widening inequality in America.
What is Inflation?
Inflation is a sustained rise in the cost of goods and services. If the economy experiences a 3% rate of inflation in 2018, then a person can expect, on average, to pay $103 for the same goods and services in 2019 that he or she was able to purchase for $100 the previous year. That may not sound like a big change, but over a longer period of time, inflation can have devastating consequences, especially to retirees and others on a fixed income.
At slightly more than 2% interest, the money loses half its purchasing power over a 30 year window. At an average 5% inflation rate, $1000 a month in 2050 dollars would only purchase as many goods and services as $226 did in 2020!
Obviously high inflation rates can be a real problem. But what causes inflation? There are at least two different possible causes of inflation: demand-pull and cost-push. To understand how they work, let’s briefly recall the fundamental economic Laws of Supply and Demand. These say that the price of a good is determined by how much of that good there is (supply) and how many people want to purchase it (demand). Suppose one of Apple’s iPhone factories is destroyed, and so the supply of new iPhones available for purchase decreases. If customers still demand the same number of iPhones, then we would expect the price of the iPhone to increase, since some people are willing to pay more than others. Conversely, if supply remains constant, but the demand for iPhones decreases, then we would expect Apple to lower the price to try to attract more buyers.
Demand-pull inflation occurs when there is more demand for goods and services than the economy is able to produce. Suppose the federal government gave everyone a million dollars to spend however they please. This would lead lots of people to purchase things they want but previously couldn’t afford: new cars, new houses, new iPhones, and so on. Since demand is higher than supply, prices go up, which means inflation.
Cost-push inflation, on the other hand, happens when there is a general increase in the cost of raw materials necessary to produce finished goods. For instance, the rising cost of oil imports in the 1970s led to extremely high rates of cost-push inflation.
In the next installment, we’ll talk about how the federal government measures and attempts to combat inflation.