Learn About Inflation in Economics: Definition, Examples, and Pros and Cons of Inflation

Inflation is the steady increase in the price of goods and services over time. It devalues units of currency (like the U.S. Dollar), resulting in consequences like higher cost of living. Think about how much a candy bar cost when you were a little kid. Now, think about how much that same candy bar costs today. Or, think about how much it cost to rent an apartment in New York City in the 1970s. Now think of how much it costs today. That price level increase is inflation.

One of the most straightforward examples of inflation in action can be seen in the price of milk. In 1913, a gallon of milk cost about 36 cents per gallon. One hundred years later, in 2013, a gallon of milk cost $3.53—nearly ten times higher.

This increase is not due to milk becoming more scarce, or more expensive to make. In fact, the opposite is true. Instead, this price reflects the gradual decrease in the value of money as a result of inflation.

The causes of inflation are various and complicated. Generally, however, there are two basic types of inflation:

1. 1. Demand-pull inflation. Demand-pull inflation results from an increase in aggregate demand for certain goods and services. So, for example, Apple can charge increasingly higher prices for their phones because they’re increasingly popular. Demand-pull inflation can be stem from a growing economy, increased government spending, or overseas economic growth. Learn more about demand-pull inflation here.
2. 2. Cost-push inflation. Cost-push inflation results from a decrease in aggregate supply of certain goods and services, often due to an increase in the cost of production, raw materials, or labor. This type of situation could be seen when wildfires in California resulted in rapidly rising prices for air filters being sold online. Learn more about cost-push inflation here.

High inflation has a wide range of negative consequences for economies. When labor wages can’t keep up with the rate of inflation of retail prices, the purchasing power of those wages decreases.

This is a particular challenge for low-income families, for whom any price increase can have serious consequences. In turn, workers’ demands for wage increases can lead to an increase in labor costs, resulting in lower profits for businesses. All of these effects of inflation can create a high degree of uncertainty in an economy, leading to decreased investment from entrepreneurs.

Nevertheless, inflation isn’t always a bad thing: in fact, a stable economy needs a stable level of inflation. Economists understand that while high inflation is a real danger, low inflation is dangerous as well. Just as high inflation can lead to permanently high interest rates, low inflation can lead to permanently low interest rates. Permanently low interest rates limits the ability of the Federal Reserve (also called the Fed, the central bank of the United States) to increase the strength of the economy in very bad times, which can lead to long, deep Recessions.

The Consumer Price Index (CPI) is a measure of inflation used by the US Bureau of Labor Statistics. The BLS surveys 23,000 businesses and records the prices of 80,000 items every month to log fluctuations and increases in goods and services. These include:

• Retail
• Transportation
• Gas prices
• Healthcare
• Food
• Housing
• Education

The Consumer Price Index tracks U.S. inflation rates, along with their impact on cost of living and purchasing power. These numbers help statisticians and economists understand the overall health of the economy. Learn more about CPI here.

Negative inflation—or deflation—occurs when the supply of goods or services is higher than the demand for those goods or services. This generally happens because the consumer base has less money or credit than they previously had. This results in falling prices for consumer goods and services.

A great example of deflation is the Great Depression, during which the cost of goods fell because people did not have access to money or credit due to unemployment, the stock market crash, and other factors.

A mild or moderate annual inflation rate is normal even when the economy is running smoothly. When inflation increases to excessively high and accelerating rates, however, it’s known as hyperinflation.

Perhaps the most famous example of hyperinflation took place in Germany in the 1920s. After World War I, Germany’s opponents demanded reparations, and forbade Germany from paying those debts in its own currency. To get around this problem, the German government printed more money in an effort to buy foreign currency they could put toward reparations. This monetary policy of printing so much money quickly devalued the German mark, which led to hyperinflation.

The United States has gone through booms and busts, leading to periods of both prosperity and recession. In order to better understand the trajectory of the rising cost of living and prices of goods, it is important to study historical inflation rates in America.

• The Great Depression. The Great Depression of the 1930s occurred due to a range of factors, including wild speculation and liberal lending that led to a bubble burst in 1929, when the stock market crashed. The unemployment rate and natural disaster also played a part. Economist and Chairman of the Fed Ben Bernanke later theorized that deflation during the Great Depression led to a reduction in value of people’s assets. Since people used those assets for collateral, the banks were faced with greater risk and therefore foreclosed on the loans. In Bernanke’s view, deflation results in a block in the cycle of lending and borrowing that is essential for moving the economy forward.
• The 1970s. Although the Fed can increase the strength of the economy by printing money, that comes at the cost of a higher rate of inflation. Higher inflation causes real interest rates to rise again and the economy to slow. If the Fed is not careful, its actions can backfire and lead to an economy with high rates of inflation but not very high GDP growth. In the 1970s, the United States experienced precisely that outcome. Inflation rose throughout the 1970s while economic growth slowed. This “stagflation,” as it was called, experience left a mark on many Americans—so much so that there are people who believe that trying to increase GDP by printing money is so dangerous that it borders on evil.
• The Great Recession. While printing money is a way for the Fed to help the economy, there are limits to this strategy. If the economy enters a liquidity trap, printing money will no longer be effective. A liquidity trap occurs when there is a lot of cash in circulation that is not spent or invested. Instead, people and institutions “hoard” their money. This is a problem because that hoarded money isn’t boosting the economy and creating jobs by being in circulation. When the Great Recession began in the United States in December 2017, Ben Bernanke, the Chairman of the Federal Reserve, responded by printing money aggressively. Economists and other commentators were worried that he would cause extreme inflation. However, because they were in a liquidity trap, most of the money sat in banks and did not circulate in the wider economy. As a result, there were huge increases in the money supply, but only a very small increase in prices. While the Great Recession was the worst economic downturn since the Great Depression, within several years (and after the Fed lowered interest rates and the government created an 800-million-dollar stimulus package), the economy was able to reach stability.

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