Why is inflation so important? And how does it impact our economy? Wondering why we should care about the consumer price index, or the Fed’s interest rates? It’s not complicated, give me three minutes and you’ll get it. Here’s the basics on inflation:
What is inflation? Inflation causes each dollar to buy less. (Deflation causes each dollar to buy more). You can look at inflation as the changing value of a dollar, or as the changing costs of items. Inflation is why one dollar used to be worth something, and why gum used to cost a penny.
What causes inflation? One theory is “demand-pull” which says if there is more demand (money) then supply (stuff), prices will increase. The other theory is “cost-push” which says if a company’s costs go up they raise their prices.
The Consumer Price Index is how inflation is measured. It is a survey of the price of a bunch of different goods and services (gas, clothes, cars, etc) and how that cost has changed. When the consumer price index goes up, that means prices in general are rising.
When interest rates drop, loans are cheaper, and consumer spending increases, which in turn causes prices to rise (demand-pull theory, remember?). So the Federal Reserve sets the interest rate as a way of controlling inflation (raise interest rates to lower inflation rates / lower interest rates to raise inflation rates)
Are we pro or anti inflation? Apparently a developed country wants to have 2-3% inflation per year. As a consumer and investor, you have to factor this into your income (a stagnant salary is actually a decreasing salary since your life costs 3% more each year) and you have to factor it into your investments (a 3% return on your investments is actually a zero return, since your money is worth 3% less each year)
too much inflation is bad because:
1) your tourism and exported goods become too expensive.
2) People living off of a fixed income have decreased spending power.
3) Uncertainty about how fast the prices will rise makes people and companies not want to spend.
too little inflation is also bad, because:
1) It means the economy is not active.
2) Inflation encourages investments (which grows the economy) because holding onto cash means losing wealth since the value of your cash is decreasing.
3) When the economy goes into a downturn we need room to maneuver the interest rates down, which we can’t do if the interest rates are already at zero.
I think that’s it! Did I miss anything? Do you get it?