Common Cents

Alright, gather round. This is going to be important.

What is inflation?

Right, so in our chat about why I should buy into CDs, you mentioned fighting off inflation. What is inflation, in simple terms?

Haha sure. In simple terms, inflation means that prices are going up over time. That’s it.

That’s really it? Then why are so many economists paid to think and worry about it?

In less simple terms, inflation measures average price trends. It would also be impossible to measure all prices for everything in the country to get this average, though. So, given we need to select some prices to watch and measure over time to get this average, we need to make some decisions. Decisions like: which prices we should look at, which prices we should not look at, and who gets final say on which is which.

So, what’ll it be? What prices do you think we should include?

I mean gasoline, for sure. The price of gas goes up every time I fill up! Seems like we’d want to track that when we think about inflation.

Does the price go up every time you fill up, though? It’s wired into our brains to make it hard to remember good news, like when gas prices actually go down, but gas prices do frequently go down, and sometimes quite dramatically! I’ve personally seen gas prices swing up in price 50 cents a gallon in just a month and then crash back down 25 cents the following month. Maybe 6 months later, they drop another 50 cents a gallon and are 25 cents cheaper than when I started watching them! And again, it may be hard to remember when gas prices go down, but, as in the example, they do go down frequently. We call things that experience wild swings in their prices like this “volatile goods”, and it makes measuring inflation using goods with lots of volatility (like gasoline) difficult.

As an example, imagine you have a few prices you’re watching and all of them, except for one, are increasing by about 2% per year. That odd-one-out skyrockets 50% one month, tanks 50% the next month, drops another 50% the next month, etc. Its price is all over the place! So, despite most prices going up 2%, the average of all these goods, including the volatile one, comes out to -20%! That doesn’t show the reality on the ground at all, though, hence why a lot of smart economists spend a lot of time thinking about this. You can’t tell people prices are dropping 20%, when in reality, most are increasing by 2%!

Inflation (prices rising) vs deflation (prices dropping)

Alright, fair enough. I’ll leave the price-picking to the economists. So with inflation, prices go up, right? Will prices ever go back down?

For some things, yes, prices will go back down. For most things though, prices will not come back down.

Remember I mentioned gasoline? Gasoline prices will likely come back down after periods of high inflation. But remember all those other goods? The prices on those goods will likely not come back down. Or if they do, they won’t go back to pre-inflation prices.

Why is gasoline special, in this case?

Gasoline is considered a “commodity”. Gasoline is produced by lots of different companies and most people don’t really mind where they get their gasoline. Gasoline is gasoline, right? Gasoline is also a key component that powers our economy. Most trucks, cars, etc. run on gasoline so, without it, we’d be in trouble! What that means is that the price of gasoline is set based on how much gasoline companies think there will be available in the future, to avoid possible disruptions to the supply of gasoline. So if they think there will be a shortage in supply, they increase prices now to offset the future shortage and to discourage over-consumption of gasoline; if they think there will be a lot of supply soon, they will lower prices. The changes in prices help to smooth demand for gasoline. That’s why you see gasoline prices sometimes coming back down, despite everything else getting more expensive.

Got it. So other prices go up and they basically get stuck there at the higher price then? That doesn’t seem like a good thing. I feel like inflation is just…bad.

Not so fast. Sure, inflation is bad when it’s too high, but mild inflation can actually be a good thing.

High inflation can really hurt folks, especially folks who didn’t have a lot of money to begin with. All of a sudden, basic goods like clothing, toilet paper, and food get way more expensive, and that hits people on a tight budget hardest. Mild inflation can be planned for and worked around, even (usually) on a tight budget, and is actually better for average people than prices going the other way, that is to say prices going down. Prices going down on average is called “deflation”, by the way.

Is deflation actually good?

Hmm…deflation sounds like a good thing then right?

You would think so, but I’d like to point out one price you wouldn’t like going down, along with all the others in the economy: your paycheck.

That’s right. Your paycheck is a price too. It’s the price your employer pays you for your time. So, as all prices start going down, the price for your time goes down too, and your wages get cut.

Yikes. Although that doesn’t seem too bad. After all, everything else is getting cheaper too, right?

Do you have a mortgage? Or a car loan? Or credit card debt?

Sure. Why?

Debt of any kind doesn’t get cheaper when everything else does. When you bought your car for $20,000, you made a promise to pay back that $20,000 in full, and the bank will collect every cent of it. Even if the price drops and the same car can now be bought brand new for $15,000, you still owe the bank the full $20,000, whether you like it or not. Oh and the bank doesn’t give two hoots that your wages got cut either. Your debt, of any kind, would get steadily more and more impossible to repay as prices and wages drop. Mild, consistent inflation, on the other hand, prevents this from happening entirely.

And this is why we have a lot of smart people thinking and worrying about inflation. We need to get it just right. Not too high, and not too low.

Yes, exactly. And it’s also why I pushed savings accounts and CDs so hard. Inflation is a necessary evil that robs our money of its value. But it also prevents us from drowning in debt due to falling prices and wages. So we live with it and limit its damage by investing our money and keeping that money making money for us. That way we get all of inflation’s benefits while minimizing its drawbacks.

Makes sense. But what causes inflation in the first place and how do we stop it?

We’ll cover that next time.

Thanks for reading.