Inflation and Its Influence on the Economy
Episode #10 of the course Fundamentals of economics by Dr. Michael McDonald
Welcome to the last lesson of the course!
Today, we’ll talk about inflation and the risks that governments face when trying to shepherd along economic growth.
People studying economics often wonder why Central Banks would ever raise interest rates. If lower interest rates help stimulate the economy, why not set rates as low as possible and leave them there?
The answer is that doing this risks the economy overheating and growing at an unsustainable rate, which in turn can cause a recession. In addition and equally of concern, low interest rates can lead to a severe problem with inflation.
What Is Inflation?
Mathematically, inflation is defined as rate of growth in the price of goods and services across the economy. It is usually measured as a percentage on a year-over-year basis. So, a 5% inflation rate means that the average price level of products across the economy rose by 5% from one year to the next. Inflation may be caused by several reasons, but the common one is that it occurs is when the economy is growing at an unsustainable rate.
As an example, in the US, inflation has averaged between 2% and 3% per year for much of the last century. In other countries, higher inflation has sometimes been a problem. In Germany prior to World War II, inflation was over 1000% per year for a time, and more recently, severe inflation has been reported in Venezuela and Iran. Moderate levels of inflation—anywhere from 4% to 10%—is common in places like China, Brazil, and India, among other developing nations.
Why Is Inflation a Problem?
Inflation can be a severe problem for an economy. If prices are rising rapidly, then the paper money that consumers and businesses hold becomes less valuable over time, meaning that the same amount of paper cannot buy as much in the way of real goods and services. So, people spend time and effort trying to figure out how to avoid the problems associated with the diminishing value of their money. In addition, rising prices makes it harder for business owners to price their own products or enter into long-term contracts. A famous example of this occurred during the Weimar Republic in Germany after World War I: At the time, people would have to use wheelbarrows of paper money to buy a loaf of bread, so they spent all their time trying to change their nearly worthless paper money into things they could actually use, like food and clothing.
Deflation and Inflation
While inflation is a common problem in many economies, there is an even worse related problem: deflation. Deflation occurs when the price of all goods and services in an economy shrinks over time, i.e. goods and services become cheaper each year. In other words, it is the opposite of inflation. In modern economic history, deflation is relatively rare, having happened most notably in Japan off and on again from 1990 to 2010. Because deflation is so rare, economists do not fully understand why it happens, but one common explanation is that deflation occurs when you have an economy undergoing structural changes that severely slow economic growth.
Deflation is a severe economic problem because it gives people an incentive to not spend money, thus artificially reducing demand and slowing the economy. As prices of goods and services fall each year, it causes people to want to wait as long as possible before buying something—the longer they wait, the cheaper the product gets. This, in turn, means that the economy is not operating at full potential.
The solution to both inflation and deflation is proper control of the money supply by the Central Bank, a topic we discussed previously.
This completes our final lesson in economics and this course. Congratulations! I hope you now feel better prepared to talk about major economic topics with friends, family, and coworkers. Good luck and thank you for taking the time to learn more about economics and its impact on the world around us.
Recommended book
The Ascent of Money: A Financial History of the World by Niall Ferguson
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