Concept of Inflation
In the world of finance phrases like mortgage backed security, prime rate, speculation and inflation get thrown around a lot yet most people don’t have a clue what it all means. After more than three centuries of evolution even the most knowledgeable can’t wrap their head around the many ways the U. S. economy works and why it sometimes doesn’t. In the next few pages I hope to explain only one of these very complicated concepts, that of inflation. Inflation, in economic terms, is the general rise in prices of goods and services over time, as well as the loss of value of each dollar or monetary unit (Inflation).
The measure of inflation is called the Inflation Rate which is measured on an annual basis. Effects of inflation on the economy are considered both good and bad. On one hand controlled inflation must occur for economic growth to be sustained, more money means more business. On the other hand, unchecked inflation can lead to deceased monetary value leading to the rise in prices. This can discourage future investment due to uncertainty in future markets. By controlling interest rates, as well as the monetary supply central banks can combat these negative effects.
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The Federal Reserve established by the Federal Reserve act of 1913,is whats known as a central bank . here in America the federal reserve is the body that decides if and when to make more money. It is comprised of twelve banks, as well as the Board of Governors who are appointed by the president and confirmed by congress. Although the Reserve is used as a tool of the government it is not a government agency. To control inflation The Federal Reserve has the authority to set reserve requirements (the amount of money banks must have on hand) and control the money supply.
The ability to make more money gives the federal reserve the power to control the “Prime Rate” which is the intrest rate the feeral reserve charges your bank on loans. This has a kind of tricle down effect, the cheaper your bank gets money the cheaper it will give it to you. The ability of the reserve to oversee and regulate the money suplly is a main tool in the fight to sustain economic growth and a strong monetary unit. Though the causes of inflation are debated in the political arena most economists agree the prime reason for inflation is the excessive growth in the money supply.
Long term inflation is caused by the supply of money growing faster than the economy. Short term inflation is caused by fluctuations in real demand or changes in the available supply of goods. Many economists favor a long term low sustained rate of inflation. Low inflation can reduce the rates of recession and allow the labor market to quickly adjust to economic down turns. A rate of 2-3% is generally seen as the target rate. The traditional way of controlling inflation is by keeping interest rates high by slowly raising the money supply. Interest rates play a key in the proper development of the economy.
Interest rates that are too high can lead to negative growth which means lost jobs and a stagnant economy. Rates that are to low encourage growth that cannot be sustained, by making money cheaper to borrow people take more risk and production outpaces demand. The Federal Reserve meets 8 times a year to set short term goals for inflation and set interest rates according to whether the economy is heating (growing) or cooling (shrinking). In the case of an overheated economy the fed will raise interest rates by shrinking the money supply to make borrowing more expensive thus slowing growth.
When the economy is growing too slowly or not at all the Fed will lower interest rates by making money more available thus making barrowing cheaper. In the end interest rates give the fed a solid rudder to steer the economy The measurement of inflation is a difficult and complex thing even for government economists. The general method consists of creating a “market basket”, which is a group of goods that represent the economy. The prices of these goods at the end of the year are compared with the price of the same goods at the start of the year. The resulting percentage is called a “price index”.
The consumer price index, or CPI, is the measure of the consumer prices, things like gasoline, food, clothing and other things consumers buy. While the producer price index, or PPI, is the measure of price in the selling of products from the factory. You can think of this as a large survey, every month the U. S. Bureau of Labor Statistics contacts retailers, the service industry and manufactures to obtain the current prices for 80,000 products (Wikipedia). Given this data economists can track change in our economy. The PPI and the CPI are tools used to maintain the climate of the economy..
Inflation is like fire, if you don’t stay at just the right distance you get to hot or too cold. On one side stable inflation is considered by most to be the way an economy grows. Without more money we can’t have more business today than we had yesterday. It’s like you live in a town of 500 and the town had 10000 dollars in circulation meaning everyone has an average of twenty dollars. When the town doubles in size, and the money supply doesn’t grow, everybody takes a pay cut or none of these new people are hired because of slowing business .
On the other hand you have the same example only this time instead of the population increasing the money supply is increased two fold, that 20 dollars you made yesterday is worth half as much in the form of goods and services to day. It is the balancing act between these two extremes that maintains a sound and sustained rate of growth. Though the risk of inflation cannot be understated the opposing side known as deflation (prices fall and the unit value rises) is considered just as bad and has been blamed for The Great Depression.
To most prices falling and money buying more seem, on the surface, to be good things but the real cost comes from the fact that falling prices mean that john the baker cant charge the same price for his cakes even though he paid for his materials at yesterdays higher costs . This causes john to lose money and not be able to hire new workers this coupled with the fact that the bank won’t lone him money due to the lack of growth in his business, stops his ability to expand.
These two forces, little known as they are, play a key role in whether you have work to go to or food on your table. Maintaining a solid rate of growth without excessive inflation is of major importance to any economy. Take the case of Brazil, the period of the 1970’s and the early 1980’s was seen as a time of never ending growth. In 1980 the growth inexplicably ended creating annual inflation up to 30,000% effectively doubling prices every 10 weeks. Credit card companies routinely charged interest as high as 25% and savings dropped by nearly 2000%.
This is known as hyper inflation, a period of rapid uncontrolled loss of unit value (how much a dollar will buy). After 5 years, the resignation of a president and many failed attempts to correct this, economists from the ministry of finance finally approached the problem with straight forward economic theory bringing interest rates under control and stabilizing inflation. By scraping their old currency and replacing it with a more stable money unit Brazil was able to fool itself into stability.
To see an example of inflation all you have to do is compare the price of gold today with the price 20 years ago. Gold is generally held as the standard that currencies are judged by (Paul). Gold can be endlessly recycled and there is little new gold entering the market. Supply and demand dictate that the value of gold fluctuates little. In 1990 the price of gold was about $400/oz in today’s market that same gold goes for $1200/oz. Bear in mind the gold has a solid real value, there for the money must be worth less per unit.
To feel the effects of inflation on your pocketbook just shove cash into a coffee can or, my preferred method, under your mattress. Make a list of all the things you can buy with this money. Now wait, without adding any money, and watch. As the overall money supply grows the list of things you can buy gets smaller and smaller. The overall effect is that your saved dollar has less purchasing power over time. In 1913 a pair of shoes that cost 1 dollar would today cost 21 dollars. That is inflation, the more money there is the less your dollar is worth.