Investor Facts: What Is Inflation?

Inflation is the rising cost of goods and services in an economy.

Inflation happens when prices rise. The opposite is deflation, which is falling prices.

Generally, prices rise for two reasons: Because wages are higher, or because goods become scarce.

Economists consider a steady rise in the cost of goods and services a sign that things are going well. It suggests that the job market is strong and that workers are able to demand broadly rising wages.

The increase in wage income tends to feed inflation as more money chases the same amounts of goods and services.

It can work the other way, however. Wages might be constant or even falling but the supply of goods could be cut off by any number of factors, leading to inflation.

An everyday example of inflation is the price of gasoline at the pump. If oil drillers and refiners overproduce, prices tend to fall quickly.

Likewise, if a refinery must shut down temporarily or oil supplies are cut off for some geopolitical reason, gasoline prices will rise.

The same pressures affect essentially everything we buy, just more slowly and less obviously.

Anyone over the age of 40, for instance, remembers when a soda from of vending machine cost 50 cents. Older folks might laugh and say “I remember 10 cents!”

A lot has changed over the years, including the size of the bottles in that machine. But the basic good being bought — sugary water with flavoring — is no different at all.

So why do prices rise? Inflation.

All currency today is backed by faith in the government that prints it. For centuries, gold or silver or both were considered the anchors of monetary value.

Governments agreed decades ago to stop relying on precious metals to support their paper notes and instead regulate the supply of those notes.

Supply and demand, how much paper currency circulates, thus sets the recognized value of a single note, such as a U.S. dollar.

Supply and demand

Capitalist economies are very good at making sure that the supply of goods and services meets demand at the lowest reasonable price.

What changes, then, is the availability of dollars in the economy. The government regulates the amount of currency through its central bank.

If the money available to companies in the form of credit increases, that tends to feed growth and wages will rise. What follows, eventually, is inflation.

Likewise, if a central bank reduces credit (by raising the interest rate), that tends to slow down borrowing and growth. Wages flatten and inflation slows as well.

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