If you’ve turned on a TV or opened your phone within the last 2-3 years, odds are you’ve heard the word “inflation” constantly.
Most of us understand what inflation feels like (and it’s not good) but why does inflation happen?
In response to Jerome Powell’s statement doubling down on a target of a 2% inflation goal last week, here is a brief explanation of what inflation actually is.
- The Money Supply Balloon: Imagine the economy as a balloon, and the money supply as the air inside it. When a central bank prints more money or when people borrow and spend more, it’s like adding air to the balloon. As the balloon inflates, each unit of currency becomes less valuable. Inflation is essentially the result of too much money chasing too few goods and services, causing prices to rise.
- The Wage-Price Spiral: Workers often demand higher wages to keep up with the rising cost of living. When businesses pay higher wages, they often pass those costs onto consumers through higher prices for goods and services. This cycle can repeat, with each increase in wages leading to further price hikes, creating a self-sustaining spiral of inflation.
- Supply and Demand Imbalances: Sometimes, inflation can be triggered by imbalances between supply and demand. When demand for a particular product or resource outstrips its supply, its price tends to rise. This can lead to localized or sector-specific inflation, which can spill over into the broader economy.
- Expectations and Psychology: Inflation is not only about tangible economic factors; it’s also influenced by people’s expectations and psychology. If consumers and businesses expect prices to rise, they may act accordingly by increasing spending or raising prices preemptively. These expectations can become self-fulfilling, contributing to actual inflation.
- Global Factors: In today’s interconnected world, global events and trends play a significant role in inflation. Fluctuations in currency exchange rates, geopolitical conflicts, and international supply chain disruptions can all affect the prices of imported goods and commodities. When these factors lead to higher import prices, it can drive up inflation in a country.
To summarize — Inflation is the result of too much money entering the economy (the inflating balloon example), causing each unit of currency to lose value. It’s a wage-price spiral, driven by rising wages and subsequent price increases, as well as supply-demand imbalances, influenced by people’s expectations and global events, ultimately leading to rising prices for goods and services.
At Chapwood Investments, we focus a great deal on inflation and the slow pain it causes investors over time. If you are not planning for inflation in your financial plan, you are absolutely falling behind.
If you are someone who enjoys learning about the economy and why things happen the way they do, you might be interested in watching a past webinar we’ve hosted with famous economist, Stephen Moore.