We all know that costs of goods have increased over time. For instance in 1940 a gallon of milk cost $.50, a gallon of gas $0.15 and a loaf of bread was $0.08. But in 2015 those same items cost $2.72, $1.99 and $2.38. We call this increased cost of goods over time inflation.
Economists formally define inflation as the increase of the general prices of goods and services over a sustained period of time. As it increases the buying power of your dollar goes down, getting you a smaller and smaller percentage of a good or service.
There is no consistency to the value of a dollar – or any currency for that matter – when there is inflation.
There is an inverse relationship between your purchasing power –your ability to purchase real tangible goods – and inflation. As it increases the purchasing power of your dollar – your ability to get things – decreases.
Let’s look at an example. If we say that inflation is at 3% annually and buying a Coke costs $1 then in one year this change would increase the cost of that coke to $1.03.
So as you see inflation causes your ability to buy things to decrease over time – your money just won’t buy the same things as it did in the past.
Causes of Inflation
The actual causes of inflation are debated by economists but two theories as to why it occurs are generally accepted.
There is the “demand-pull” theory. This type usually occurs in growing economies, and is caused by supply and demand. In other words there are too few goods for the demand and this drives prices up.
The other generally accepted theory is the “cost-push” theory. This is based on increased costs to the business producing goods. Things that can increase for companies include wages, taxes or increased cost of importing raw materials.
When a company has increased costs, they must increase prices to maintain their profit margin.
Though in the public mind inflation is often seen as a bad thing this isn’t necessarily the case.
Inflation can effect individuals in different ways. Whether the change is anticipated or comes unexpectedly is also a determining factor as to whether inflation is seen as being bad.
For instance if inflation occurs at a rate that what most people expected it to then we can compensate for the increase and the cost of inflation isn’t all that high. Examples of such compensation include adjusting interest rates or having cost of living increases built into wages.
However, when the change is unanticipated problems can arise. Consumer spending can decrease hurting economic output and those on fixed incomes can suffer as their standard of living due to decreased spending power diminishes.
Inflation and Wages
Though people will always complain about the rising cost of goods, it should be remembered that wages should be increasing commensurately.
Inflation is only really dangerous when its rise outpaces the similar rise in wages.
It is also a sign of growth. Little inflation or even deflation can be the sign of a weakening economy.
How inflation affects you depends on your personal situation as well as the overall economy.