Inflation

So I am not entirely sure how many people check to see that I am an Economics major in the About Me section, but that is what it turns out I am. So naturally my friend figured it would not be to hard for me to explain a few simple economic phenomena to her the other day, one of which was inflation. She basically asked why it exists and I stumbled around trying to explain it for a while and that made me a little frustrated with myself and I went straight home, pulled out my old Intro to Macroeconomics book and looked it up.

Inflation, according to my book, is a process in which the price level is rising and money is losing its value. Basically the price of things as a whole have gone up and your money is now worth less than its previously was in terms of your ability to purchase these goods. There are several ways for this to happen, the two most common of which are demand-pull inflation and cost-push inflation. Demand-pull inflation is where the demand for a good is suddenly higher and the price of it is then bid up by consumers. Cost-push inflation is where the cost of raw materials may rise and this in turn makes the end good more expensive. When the cost to make the good goes up, surprise surprise, so does the final product. These are the basic ways in which inflation can occur and by no means the only ones, its a rather complicated process it turns out and I feel a little better after refreshing my understanding as to why I could not explain it immediately.

However, how do we control inflation and why do we not try to make inflation zero, are two good questions that I also tried to answer. The answer to the first is that the Federal Reserve Bank is usually charged with controlling inflation by controlling the interest rates. If the Fed lowers the interest rates then people will be more willing to consume; if the Fed raises the interest rates people will be encouraged to save and discouraged from spending as the cost of loans goes up with higher interest rates. Knowing these are the two main ways in which inflation are controlled makes it a little easier to see why our inflation is normally kept to three or four percent instead of zero. If the Fed tries to curb inflation all the way to zero by raising interest rates, it is in effect cutting the spending habits of the people and the economy will slow and this can lead to recession. If the Fed lets interest rates become zero people will be glad to spend and borrow as much as they want and inflation will quickly rise at a pace that is quite harmful to the economy.

As you can see, by allowing some inflation to occur it is actually good for the economy because it promotes consumption, which is the basic building block of our economy. When people see that there is inflation in the economy they should not make the jump in reasoning to assume it is bad and that they can no longer afford things or that the government is not doing its job, but rather ask themselves how much inflation is occurring and whether or not it is a healthy amount.