What you should know about inflation. Hint: It’s NOT rising prices.

 

What you should know about inflation. Hint: It’s NOT rising prices.

We’re hearing quite a bit about inflation of late. After the term almost completely dropped out of our everyday lexicon, it is now springing up again for the first time in decades. That means it’s time for a review—particularly for those under the age of 45 who probably have no real experience with it.

Despite the media headlines, rising prices don’t always signal inflation. There are lots of reasons why prices may increase. A frost may wipe out a citrus crop causing orange juice prices to rise. Hot demand for a new video game console may drive up its price. These ebbs and flows of prices go on all of the time, but that’s not inflation.

What exactly is inflation?

As its name implies, inflation means something is getting bigger. In this case, it’s the money supply…or as economists say in shorthand, ‘too much money and too few goods.’ That devalues the currency making each dollar worth less and, therefore, you need more dollars to buy the same amount. Don’t quit reading yet. Let me walk you through how this works.

Years ago, I taught college freshman-level economics, and I would demonstrate inflation this way. At the beginning of class as my students filed into my classroom, I would hand them all some play money. I was always a bit amused to see who sorted their currency into separate denominations, who hid their stash from prying eyes, and who just piled it on their desk. (I’ll leave that to the psychologists to analyze.)

Next, I would hold up a bag of M&Ms and allow the students to bid on the candy. Whoever bid the highest, often those who had skipped breakfast, would ‘buy’ the candy. We had three rounds of bidding with final prices ranging from $10 - $15. Remember, this was play money.

Then came round two. I passed out additional dollars to each student and began a new round of bidding. This time, those M&Ms ‘sold’ for between $40 and $50. Some enterprising students even pooled their money in order to outbid their classmates. (More fodder for the psychologists.) But it was very clear that as more dollars circulated in our mini economy, it drove up prices. And that’s exactly how inflation works.

In the real world, the Federal Reserve manages how many dollars circulate in the U.S. economy using various monetary tools like manipulating interest rates and/or buying and selling Treasury bonds. I won’t go into the detail here, but good policy reflects a slow and steady increase of dollars to match the production of goods and services. That’s what keeps overall prices fairly stable.

In my classroom, I used the absurd example of dispensing cash to illustrate a point. No one in their right mind would actually fire up the printing presses and hand out wads of cash to virtually every man woman and child in the U.S. And then distribute more. And then allocate even more money for families. And then pass huge spending bills…  Or would they?

Why you should care?

And now you know why we currently have inflation. It effects everyone, but those on low and fixed incomes are hit especially hard. This isn’t a political commentary. It’s an economics lesson to make the esoteric a bit more understandable. And if trends continue, you can expect to see your dollars worth less. Not worthless. Yet. But worth less.