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How to Understand Inflation

Updated on February 2, 2010

The Ups and Downs of Money

Inflation is all around us, it seems.  We hear about it on the nightly news, read about it in the newspaper (even if we don't open the business section), and we hear about it from our family, friends, and colleagues.  In each case, those who mention inflation are perplexed or worried about its rise.  Yet, what exactly is inflation?  This article may help you to visualize it so that you may better understand it.

What most people do seem to be sure of with regard to inflation is that it means a rise in prices.  For instance, if this week lettuce is 1 Euro a head and next week it's 1.50 Euro, that's a definite rise in price.  Of course, the rise in the price of lettuce alone does not necessarily constitute inflation.  There may be a draught in the nation that the store receives its lettuce from, either reducing the number of heads of lettuce that survive, or necessitating a higher price to pay for extra water that is irrigated in.  Either way, this results in a higher price for lettuce at the store.

However, if many products on the market become higher priced at the same basic time, such as food, clothing, and natural gas, then chances are, this an indication that inflation is on the move.  To better grasp this, then, we need a little more information.

If there's one aspect of economics that nearly everyone seems to grasp, it's supply and demand.  This, put succinctly, means that the greater the supply, the less the demand, and likewise, the greater the demand, the less the supply.  Let's break this down, by each of its 2 parts, that we may in turn understand inflation better.

The greater the supply, the less the demand.  This means that if Apple puts out 18 million I-widgets, (the latest in widgeting, dontcha know) at $10 each, but there are only 4 million people that want to buy one right now, then the I-widgets simply aren't that popular, and so the price will go down.  There are simply too many of the I-Widgets, and the retail stores don't want them sitting around and collecting dust.  Thus, excessive quantity makes for reduced desire.

Consider as another instance, the value of water.  We are constantly hearing about the lack of water in the world.  Yet, in places where water is not so in demand such as the United States, the price of water is still fairly cheap (for the time being, at least).  In other regions, such as many parts of Africa, whiskey and soda are cheaper than water, as water is so very scarce.  This is ironic, especially as water is so important to life, whereas something like diamonds, which holds little value to life at all (save for to impress someone), is very expensive; this is purely due to the scarcity of diamonds, difficulty in procuring them, and the great demand for them.

On the other side of supply and demand we have the rule of 'the greater the demand, the less the supply.'  This is an even easier idea to conceptualize.  The more something is wanted, the more it is sold, and so the less of it that is left to go around.  Consider your grandma's great pumpkin pie.  If she makes 2 pies and there are 6 of you eating together, the pie doesn't stand a chance of staying on the counter; it will all be quickly gone.  This also works in any store in the world, and so it is with the rules of basic supply and demand.

Now, let's return to inflation and its mode of existence: excessive money.  There are many theories about what causes inflation, yet of all the causes, the reason that is most agreed upon by economists is the excess amount of money in a country (or even throughout the world).  Very often, as during the Great Recession that began in 2007, money is suddenly witheld from being lent out by the banks (the very same thing happened in the Great Depression).  Thus, more demand than supply; money (and moreso, commodities like gold) become more valuable.

However, as a part of the government's plan to get more money circulating, more money has been created.  In fact, as of late 2009, the Federal Reserve, colloquially called the Fed, has been "sitting on" around 1 trillion new dollars!  They've also released about the same amount into the marketplace, via loans and government bonds, as well as via the creation of new jobs.  As of early 2010, there is very little inflation, save for the natural rise that comes from economic expansion.  Yet, this could change overnight.

Let's imagine a worse-case-scenario via a thought experiment.  Imagine that the government begins producing more and more money without stop.  Suddenly, it's very easy to get loans.  Everyone is getting loans and so, many people get raises at their places of work.  People are now making more money, so they are also buying more (their purchasing power has gone up, to use the economic parlance). 

Yet, because people are now buying more, the stock on the shelves is disappearing faster.  The stores don't want to have empty shelves, nor do they want to miss out on all of the extra money that can be had by raising the price.  So, they raise the price of their all or almost all of their goods.  (Again, it's important to reiterate that while the stores do this partially out of greed ("good business"), prices are also raised for the practical reason of not having empty shelves.

Now the government is printing up so much money that even the smallest of banks are loaning it out (and prices are going yet higher).  Thus, while there is more money to be had, everything also costs more.  This situation, in fact, is what happened to Germany before the Second World War (and sadly helped bring Hitler into power -though that is another story).  Money became so available and prices so high that, reputedly, people would have to use a wheelbarrow to carry enough money just to purchase a loaf of bread!  Now THAT'S "loose" money and high inflation!

Yet, let's take our thought experiment even a bit further.  In fact, let's get nuts.  Suppose that nothing is stopping the government from making easily-acquired money and banks are just as quick to pass it out.  Now money becomes so common that people drop their bills on the ground (much as many throw pennies out into the streets).  Despite this money being on the ground, nobody bothers to pick it up.  Even homeless people pick it up initially, but soon realize that $5 or $10 or even a $20 bill will buy them little more than a stick of gum. 

Shortly thereafter, a state of emergency is called.  Money is so common that city sweepers can't keep it off the ground.  It's piling up in the roads and on the sidewalks.  It's everywhere.  At first, people attempt to throw it away until local governments announce it is filling up the landfills.  People then try to flush it, but quickly realize that it doesn't flush well.  In fact, because of this new practice, the work of plumbers quadruples overnight (as do their rates); however, they refuse payment of money, and want payment by gold, silver, barter -anything but money.

 Soon enough, people begin burning their money (this was also done in Germany before WWII, so that the Germans could stay warm).  People want it out of their lives, and soon small fires are found all over the planet, where people are eliminating the excess bills.  The air begins to be polluted with burning money.  Eyes water and throats burn.  The term "filthy lucre takes on its most profound meaning, and everyone has had their fill of money.

That is, of course, purely fantastical, but clearly shows how even money can become a worthless burden if there is too much of it.  That, in a stretched-out, somewhat specious sense, is inflation.  Fear it.


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