Inflation - What You Need to Know
In economics, inflation is an increase in the general level of prices of goods and services in an economy over time. As prices increase, the purchasing power of money decreases. In extreme cases of inflation, citizens spend their money as fast as they can before it declines in value. High inflation discourages people and businesses from saving money, destroys the value of existing savings, and erodes wealth.
Causes of inflation include the following:
- The expansion of the supply of money by the federal government faster than the rate of economic growth. This is often done by printing money in order to pay for government programs.
- Deficit spending by the federal government made possible by borrowing funds. This has the effect of allowing the government to spend money in excess of tax revenue. Deficit spending increases the demand for goods and services, thus contributing to inflation
- Natural disasters such as earthquakes, tornadoes, and hurricanes can rapidly increase the demand for certain goods and services while reducing or destroying the supply of the same goods and services.
- Monopolies such as the Organization of Petroleum Countries (OPEC) or near monopolies such as Google can increase prices because of their dominance in the market.
- Labor unions that are successful in forcing employers to pay for “make-work” projects (featherbedding) making it necessary for those employers to pass the extra costs on to the buyers of the products or services. An example is forcing the operators of diesel locomotives to employ firemen that were needed on coal fired locomotives used in the nineteenth century.
- Taxes that target a specific industry, force the industry to pass the cost of the taxes on to the consumers of the products or services, thus causing inflation.
Effects of High Inflation
Nearly all of the effects of high inflation are negative and include the following:
- It erodes the value or purchasing power of savings making it less likely that people will accumulate cash savings for investment;
- It increases the opportunity cost of holding money;
- It creates uncertainty for businesses and families trying to make financial decisions;
- It encourages the hoarding of real assets out of concern that prices will substantially increase in the near future;
- Purchases and sales are made on credit by buyers and sellers of goods and services attempting to compensate for anticipated inflation;
- Interest rates on loans for homes, consumer goods, automobiles, equipment, and inventory increase to compensate for the loss in value of money;
- Barter becomes more common as the currency declines in value;
- It encourages wage and price controls which tend to result in shortages and supply chain disruptions;
- Conflicts arise between employees and employers as employees attempt to increase their incomes to compensate for increases in the cost of living while employers attempt to contain the rising cost of producing goods and services; and
- People develop a loss of confidence in the currency and the economy which sometimes leads to social unrest.
Monetization of the Debt
Monetization of the debt refers to the government intentionally creating hyper-inflation after creating a level of debt so high that it cannot be repaid except by means of printing money. The newly printed money is used to repay debt with highly devalued dollars. This has the effect of creating even more inflation.
Hedges against Inflation
While individuals have limited control over the causes of inflation, there are ways to hedge against the risks associated with inflation. Following are some of the ways people protect themselves from high inflation:
- Purchasing real assets such as improved real estate or land with available investment dollars;
- Avoiding low yield government or corporate bonds that are likely to decline greatly in value with increasing interest rates that always accompany inflation; and
- Taking full advantage of tax-deferred retirement funds by establishing Self-Directed IRA or 401K accounts and then investing the funds in inflation protected real assets.
The Shrinking Value of the Dollar
|Amount it took to equal $1.00 based on the value of a 1913 dollar
History of Inflation in the United States
- 100 in 1940 has the same buying power as $1,644.44 in 2012.
- 100 in 1950 has the same buying power as $955.27 in 2012.
- $100 in 1960 has the same buying power as $777.77 in 2012.
- $100 in 1980 has the same buying power as $279.39 in 2012.
- $100 in 1990 has the same buying power as $176.14 in 2012.
- $100 in 2000 has the same buying power as $133.69 in 2012.
Wage Push Inflation
Wage push inflation is caused when the state and federal governments increase the minimum wage based on political considerations. These increases are not based on merit or increased productivity. When the federal and/or state minimum wages are increased, they trigger wage increases for other employees who are being paid more than the minimum wage. For example, when an employee who is being paid $3.00 per hour over the minimum wage finds that the minimum wage has been increased, he or she is almost certain to expect and demand an increase in his or her wages. In addition, many employees who are covered by union contracts get paid a certain amount over the prevailing minimum wage. When the minimum wage is increased, these union members automatically receive a wage increase regardless of their productivity or merit.
When employers are required by law to pay employees more money regardless of productivity or merit, they nearly always increase the price of the goods and services they produce and sell into the market, thus adding to overall inflation.
Cost push inflation creates a circular effect on wages, as higher wages will be demanded to compensate for the increased prices of goods and services.
Cost push information is a major contributor to the overall rate of inflation.