101: Inflation Part 1


In our first post we examined how and why interest rates are set by our central bank, the Federal Reserve, as well as the importance to small business owners of the level and direction of rates. At the time, we touched upon the “dual mandate” that the Fed has to provide both price stability and maximum employment.

When we speak about price stability in terms of the overall economy, we are touching upon the concept of inflation, which can be defined as a general rise in the price of goods and services over a period of time.

More specifically, in the U.S. we are speaking of a rise in the Consumer Price Index (CPI). The CPI is calculated by the United States Bureau of Labor Statistics and is defined as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

At first blush we might think that inflation is, by definition, a bad thing ­­– after all, nobody likes having to pay more for stuff. A closer inspection, however, reveals that inflation is a more nuanced concept that cannot simply be labeled as good or bad.

Mainstream economists tend to agree that a low, steady inflation rate, generally in the range of 2-3% a year, is best for economic growth. To illustrate why this makes sense, let’s look at two possible alternatives to the “low and steady” scenario preferred by economists and central bankers.

Hyperinflation is an extreme form of inflation that has been experienced several times throughout history, notably in Germany in the 1920s and in Zimbabwe in the 2000s.  In both of these cases, inflation levels reached nearly 6,000% a month and led to oddities such as a postage stamp costing five billion Deutsche Marks and citizens exchanging wheelbarrows full of cash for a loaf of bread.  It’s not difficult to imagine how this scenario wreaks havoc with the daily lives of everyone affected and why central bankers seek to avoid it all costs.

At the opposite end of the spectrum is deflation, the situation where the price of goods and services tends to fall over time.  While this may sound like a positive – who doesn’t like a good sale? – in reality, deflation can have devastating effects on an economy.  If the price of everything is always getting cheaper, then nobody has an incentive to buy anything today.  And if people aren’t buying things, then companies can’t sell as many products and don’t need as many workers.  This of course can lead to higher unemployment, which further reduces the demand for goods and services and can wind up with an economy that is trapped in a deflationary spiral.

Given the nasty alternatives, it is easy to see why central bankers like the “Goldilocks” situation when it comes to inflation, not too hot to risk running into hyperinflation, and not too cool to risk tipping into deflation.

In our next post, we’ll take a look at how the Fed attempts to manage inflation and how inflation can affect small business owners.


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