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What is 'Inflation'

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.

BREAKING DOWN 'Inflation'

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%.

Real World Example of Inflation

Inflation is generally measured in terms of a consumer price index (CPI), which tracks the prices of a basket of core goods and services over time. Viewed another way, this tool measures the "real"—that is, adjusted for inflation—value of earnings over time. It is important to note that the components of the CPI do not change in price at the same rates or even necessarily move the same direction. For example, the prices of secondary education and housing have been increasing much more rapidly than the prices of other goods and services; meanwhile fuel prices have risen, fallen, risen again and fallen again—each time very sharply—in the past ten years.

Inflation is one of the primary reasons that people invest in the first place. Just as the pack of gum that costs a dollar will cost $1.02 in a year, assuming 2% inflation, a savings account that was worth $1,000 would be worth $903.92 after 5 years, and $817.07 after 10 years, assuming that you earn no interest on the deposit. Stuffing cash into a mattress, or buying a tangible asset like gold, may make sense to people who live in unstable economies or who lack legal recourse. However, for those who can trust that their money will be reasonably safe if they make prudent equity or bond investments, this is arguably the way to go.

There is still risk, of course: bond issuers can default, and companies that issue stock can go under. For this reason it's important to do solid research and create a diverse portfolio. But in order to keep inflation from steadily gnawing away at your money, it's important to invest it in assets that can be reasonably be expected to yield at a greater rate than inflation.

For further reading on this subject, check out the Inflation Tutorial.

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