Alright, gather round. This is going to be important.
How does inflation spread through the economy? A recap
If you’d like a full explanation of inflation and its causes, check out this previous post.
Just as a recap here, inflation is the increase in prices of things over time. Low, consistent inflation is easily accounted for and only becomes a problem when prices rise too quickly. This is usually due to an economic shock of some kind and goes something like this:
- Demand goes up in general for stuff in the economy.
- Businesses adapt by raising prices, including wages.
- Raising prices and wages cause people to buy more now, to get ahead of future price increases.
- Go back to 1 and run it through again.
So inflation is a self-feeding cycle?
Exactly. If inflation is allowed to keep going, it feeds itself and grows worse and worse.
And now you’re going to tell me how we stop it.
How we stop inflation
To stop inflation, we need to break the self-feeding cycle. There are technically a couple of ways to do this, but by far the most common is to raise interest rates.
Wait, interest rates? We can just…raise them?
Well, you and I can’t, but the Federal Reserve (or “The Fed”, for short) can! The Fed can raise a special interest rate, called the ‘federal funds rate’ that encourages all the other banks in the country to raise their interest rates too. And, just like that, the interest rate goes up across the country!
Okay, so the Fed indirectly raises interest rates nationwide. How does that stop inflation?
By making money more expensive. Remember when we talked about interest before? Interest is the money charged by the lender for taking a risk giving you money. The interest is, therefore, the cost to you for borrowing the money. As interest rates go up, the cost of borrowing money goes up too; as interest rates go up, money, in the form of loans, becomes more expensive
And people realize this and stop taking out loans.
Exactly. Not just individual people, either. Companies stop taking out loans too! As people and companies slow down purchasing and stop borrowing due to the increased interest rates, demand across the economy slows down. As demand slows down, people stop buying as many things, businesses stop making as many things and stop raising prices quite so quickly. And when the increase in prices slows down…
Inflation, the general increase in prices, is slowed down.
Yup! And just like that, interest rates have broken the inflation cycle.
Can there be too much of a good thing?
So, the idea is to curb demand by raising interest rates, right?
Correct.
So, why don’t we just jack up rates to like 100% and beat the demand down right there. Seems faster than slowly increasing and tweaking interest rates like the Fed seems to do.
A couple of reasons. First, people need to believe the Fed is serious. If they do something crazy, like setting interest rates to be 100%, people will think they’re playing games and won’t change their demand as a result. The interest rate hike has to be reasonable and believable. In other words, a 100% interest rate isn’t reasonable, so it won’t be believed, and people won’t take it seriously.
So, why not, say, 10%? That’s reasonable and believable. The issue here is, if interest rates rise too much, too quickly, demand won’t just fall, it’ll collapse.
People will take the change seriously, turn inwards, and cease all purchasing of all items but the very bare essentials. This will essentially eliminate most demand and companies will cut staff, cut production, and cut costs brutally in response. There will be far fewer goods available and no one will be willing to buy them, simply because they are FAR too expensive, due to the sudden, huge increase in interest rates.
That total shutdown sounds bad for the economy.
It is! In fact, it’s called a ‘recession’ and it’s one thing that can happen when the Fed tries to squash demand too much. As interest rates skyrocket, people will find it hard to finance most things, so demand dries up and both people and businesses suffer. If this continues, the expectation that financing will be expensive and goods scarce will set in, and voila, we have a recession. People will continue to cut expenses, businesses will continue to cut production and jobs, and the economy will crash as a result.
So it’s critical the Fed gets the interest changes right.
Absolutely critical. Too much adjustment too quickly and we get a recession. Too little adjustment too slowly and inflation continues to run rampant.
Hence all the smart people who are paid to think about this all day.
Indeed.
This wraps our discussion of inflation. Next up: “What is debt?” and why you should have at least one or two credit cards.
Thanks for reading.
Common Cents 