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The first question that we should ask ourselves before diving into this post is how often does inflation occur? The answer to this is quite often! Inflation is an essential part of a healthy economy. The Fed (Federal Reserve Board System) has a long-run annual inflation goal of 2%. We shouldn’t fear inflation in small amounts, because it allows the Fed to intervene to stabilize the economy. But when there is too much or too little inflation it can impact your wallet negatively, and more importantly your overall wealth!
Have you gone grocery shopping recently? Surely, you noticed that the eight items you purchase from the produce section now cost three times as much. Yep, that’s right, the ingredients to make your favorite veggie stew have gone from $10 to $30 over two years!!! Absurd right???
That’s the horror of what inflation can do in just a short period when it gets out of hand.
How Does Inflation Occur?
There are tons of factors that drive inflation. I’ve enjoyed learning about all things that affect money (and still do), but I must say, this topic is both extensive and mind-numbing. I would be lying to you if I told you it was my favorite topic to learn in my macroeconomic studies. But I’m going to try to make this as interesting as I possibly can!
For the sake of simplicity and not boring you to the highest extent, we will discuss the main players in inflation and how they impact inflation:
- Consumers
- Businesses
- Government
- The Fed (Federal Reserve Board or U.S. Central Bank)
Consumers
A consumer of goods and services would be you and I. We are consumers of food, clothes, accessories, houses, entertainment, etc. Whenever money leaves your wallet to purchase, it is to consume a good or service.
A shortage occurs when there is an insufficient supply of a good or service. This means there is not enough of the product available to meet the demand. As a result, prices rise until the market equilibrium is reached. Vice versa If there is an excess supply, then the good or service is more abundant than demand. The price of goods or services will fall into equilibrium.
The best example of this is gas prices! At the time of this post, the war between Ukraine and Russia is still ongoing. This war has been a major cause of gas prices soaring north of $5 a gallon in some parts of the U.S. It should be noted that 8% of U.S. gas imports were from Russia in 2021, according to the U.S. Energy Information Administration. Due to America not being a fan of how Russia has been treating its fellow neighbor (Ukraine) with the war, America put sanctions on Russia. Part of these sanctions banned the import of gas from Russia to the US.
As you could probably imagine this put a strain on the supply of gasoline for the U.S., while the demand for gas has remained consistent (since our lives in the U.S. resumed as usual). This lack of supply caused inflation in gas prices.
This is just one of many scenarios of how inflation occurs for consumers.
Businesses
Businesses are the entities that sell consumers (you and I) goods and services. They can be impacted by inflation in the same way consumers can but on a much greater level! This can make or break a business and ultimately result in changing its operations or causing it to fail.
There are two primary types of goods a business can offer. Business goods can be elastic or inelastic. Depending on which type a business primarily offers it could be very difficult for them to survive inflation in labor (employee pay) or the cost of supplies (to make goods).
Elastic Goods
Firstly, is an elastic good, this would be a good that loses consumer demand if prices increase. A hypothetical example would be a vanilla-scented candle made by Litty Lit is normally $2. All of a sudden the cost of vanilla scent has soared due to less supply. This would mean it’s more expensive for the business to create vanilla candles. The candle now costs the consumer $10…
For a reasonable person such as you and me (I hope lol), this would be a ridiculous purchase. Demand would probably decline for this candle with the price going up 5x! Litty Lit will either need to discontinue the vanilla scent candle, or unwisely continue producing it and potentially go out of business.
Inelastic Goods
Secondly, are inelastic goods, these would be goods that no matter how limited the supply, it is essential and we will pay the outrageous price to obtain them. An example would be a gas company such as Shell or Exxon. No matter how high the price of gas goes, they can pass the cost over to you and you will pay it, plain and simple. Depending on where you live you’ll need gas to get to work, school, or even simply groceries. These businesses know that and can charge accordingly! This is where electric cars and public transit win!
Government
The federal government has two ways to influence the economy, these are called fiscal and monetary policy. The Fed (a separate branch of the government) controls monetary policy.
“Fiscal policy is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.”
International Monetary Fund
Government Stimulus
Do you remember in the year 2020 after the offset of the pandemic, the government rolled out a $2.2 Trillion stimulus package? OF COURSE, YOU DO! That’s when the majority of us received that hefty $1,200 deposit to our bank account.
Those stimulus checks were provided to the American people because unemployment in the country went nuts due to the pandemic restrictions. The hardest hit was the service industry, bars in particular. Because bars weren’t able to have customers, they weren’t making money so the employees couldn’t get paid. Employees then lost their jobs and couldn’t pay their bills, and the companies that collect their bills weren’t getting paid. A HUGE CYCLE OF MONEY LOST!
With that being said the government had to support more than just the American people. They had to incentivize and compensate businesses to keep workers employed, facilitate new loans and grants to large and small businesses, increase aid to states, spend more on hospitals, offer targeted tax relief, and enact other tax and spending changes. See a breakdown of how the funds were used in the Committee for a Responsible Federal Budget article.
Effects of Government Stimulus
Of course, this was a lot of money for the government to dump into the economy at once. Although the stimulus was very much needed to keep the American people afloat, it put a lot of extra money into the economy. This contributed to inflation later down the line, as there was a portion of the population that received the stimulus money that didn’t necessarily need it to make ends meet.
This left a whole bunch of money in the economy unspent and saved. When the pandemic restrictions loosened consumers began spending money again. Consumers had a high demand for goods and services since they have been pent up at home for so long. Needless to say, supply is not there as businesses have not been operating as they should have for almost two years. This was a contributor to inflation going through the roof!!
The Fed (Federal Reserve Board or U.S. Central Bank)
“The U.S. central banking system—the Federal Reserve, or the Fed—is the most powerful economic institution in the United States, perhaps the world. Its core responsibilities include setting interest rates, managing the money supply, and regulating financial markets.”
Council on Foreign Relations
You see it and I must agree! I fully believe the Fed is indeed the most powerful economic institution. They print the money of one of the world’s strongest currencies!!! The weight of the world is on their shoulders because other countries such as Panama, Hong Kong, Belize, and many more also peg their currency to the US Dollar for stability (so the foreign currency holds its value). So although the primary responsibility is the US there is more at stake.
The Fed observes data such as unemployment, wages, and consumer price index (the trend in the cost of goods) to make decisions to control interest rates. The fed meets about eight times a year or every six weeks to discuss the data. There are far too many variables to discuss them all, but knowing that the fed influences interest rates are key.
Interest rates control the cost of borrowing to buy goods and for savers to save. This affects interest rates on business loans, mortgage rates, rates for car loans, and how much interest you accrue on your savings account.
When inflation is high the Fed will hike interest rates to bring prices down and vice versa. The rule of thumb for this is that when interest rates go down prices go up and when interest rates go up. This is how the Fed combats inflation.
How to Fight Inflation
Inflation is an increase in the general price level of goods and services. If inflation continues at its current rate, then the purchasing power of money will decline. As a result, inflation makes it harder for consumers to buy things with their dollars.
Over the long term, there are several ways that you a consumer can protect your money from losing value. As we know the annual target inflation rate for the fed is 2%. With that in mind, we should invest our money for returns near or above 2% annually to maintain its value! The stock market and high-yield savings accounts are a perfect way to start!
