Forgot your password?

How Inflation Works

By Edited Oct 16, 2015 0 1

            We hear it all of the time, “The price of everything is going up!” Our news media talks about price gouging at the gas pump and how the cost of food is skyrocketing. Every week we read about more people who are getting on food stamps to help pay with groceries. It seems at every turn we’re told that prices are going up, but no one is talking about why. On some very select websites that are off the beaten path, you hear about the reasons behind the recent spike in prices. Sites such as zero hedge and of two minds are examples of sites talking about the underlying causes of economic issues.

            Before we begin to understand why the price moves up or down, we must understand value. There is an old saying that Europeans used to use, “Value is the same, currency has changed.” The saying originated because before the Euro became the common currency in Europe, the continent had multiple currencies from different countries. The value of each currency was different. Therefore, the cost of a loaf of bread or pound of sugar was different depending on the value of the currency.

            Value always stayed the same. A loaf of bread was always a loaf of bread as a pound of sugar always remained a pound of sugar. It was the economics happening around the bread and sugar that changed. Hence the phrase, “Value is the same, currency has changed.” If a Frenchman crossed the border into Germany and tried to buy sugar in Francs, the German sugar salesmen would want to know the value of his currency (the Deutschmark) in relation to the franc so he can price the sugar appropriately. If the franc was weaker, he would require more of them for payment.

The Two Different Types of Inflation

            The first type of inflation is easy to understand. The price of a good or service goes up when there is less of the good/service and demand is high. An example of this is when major catastrophes happen and the price of food and fuel skyrockets. Inflation like this is understandable because the much needed supplies of food and fuel dwindles, therefore increasing the price. In this scenario, if someone finds a way to clean water or manufacture fuel, then they can raise the price accordingly. As the region that was hurt by the natural disaster begins to rebuild and infrastructure is restored, the price of water and fuel will decrease as more providers move in to compete with the market.

            The second type of inflation is man-made. Inflation occurs when a country simply prints too much money and floods the economy with the new currency in which it has created. Remember back to the old European saying of “Value is the same, currency has changed.” This saying comes from generations of different kings, presidents, and prime ministers printing and borrowing too much money.

            This is how it works. Let’s say a small country has $1 million dollars in circulation out in the economy. If you added up all money in people’s savings accounts, wallets, etc. it would add up to $1 million. For our example we’ll say that in this economy the cost of a coke is $1. If the currency outstanding is kept at the $1 million mark, then the cost of the coke will stay at $1. But what if that country does something unwise and begins to borrow and print money? By borrowing or printing they send an influx of more dollars into the economy. If they borrow $4 million, then there will be $5 million outstanding dollars in the economy. The original $1 million plus the $4 million borrowed. In this fictitious example, the price of the coke will not stay at $1. At first it will as the new dollars are pushed through the economy. But reaction of the new dollars coming will result in the price of goods and services increasing. The coke price will rise to $5, matching the new influx of dollars.

            The reason the price of the coke inflated wasn’t because the coke became better. The taste didn’t get better, nor did the caffeine become more potent, the sugar sweeter, or the customer received more ounces of the soda pop. The price rose because the government unwisely borrowed and printed more money, resulting in flooding the economy with more dollars.

            The economic effect this has on pricing is that each dollar become worth less. When there are few dollars in an economy, each dollar has more purchasing power because of supply and demand. The supply of dollars is low, therefore demand is high. When demand is high, each individual dollar is more powerful. We’ve all heard our grandparents talk about a gallon of gasoline costing 0.10 cents when they were young. Today that same gallon is $4. The gasoline didn’t change. It didn’t become more powerful or give us better mileage. And there is certainly no shortage of oil in today’s world. What happened? The currency became weaker. Therefore, it cost more dollars to buy the same product. “The value of the gasoline is the same, currency has changed.”

            This is a hard concept for people to grasp. I had trouble with it for a while.  It was unsettling that money printing made my home currency weaker; therefore people demanded more of the dollars for goods and services because they had lost trust in our currency. When a population trusts a currency, they demand less of that currency as payment. It’s why a gallon of gasoline in the US costs $4, whereas that same gallon is Mexican pesos costs 45 pesos per gallon. In our currency, the demand is 4 units of US currency, but demand for Mexican units is 45. This is because people trust the peso less and demand more as payment.

            As one can imagine, 99% of the time inflation is caused by unwise governments printing and borrowing too much. If you ever hear the terms bailout, stimulus, or aid package, you are hearing the whirring of the printing press in Washington DC. Our politicians may be bailing out various companies under the guise of helping us all, but the end result is that more dollars are now in our country. This means each individual dollar has lost value. Therefore, everything costs more.

            This is how inflation works.

Bureau of Engraving and Printing


Aug 27, 2014 8:37pm
The second type of inflation is mention is essentially a hidden tax. The tax is paid in a loss of purchasing power. Food and energy prices are constantly rising like you mention. We should question why prices always tend to increase and ways to avoid the loss in purchasing power.
Add a new comment - No HTML
You must be logged in and verified to post a comment. Please log in or sign up to comment.

Explore InfoBarrel

Auto Business & Money Entertainment Environment Health History Home & Garden InfoBarrel University Lifestyle Sports Technology Travel & Places
© Copyright 2008 - 2016 by Hinzie Media Inc. Terms of Service Privacy Policy XML Sitemap

Follow IB Business & Money