Econ 101: Inflation and the Economy

Our listener Eric has made an appearance in the past to school us on bonds. Today he’s back to teach us about inflation.

 What Is Inflation?

 Economic concepts can be broken down into the micro and the macro. Micro looks at the smaller picture concerning the behaviors of individual consumers and businesses. Macro is the study of the economy as a whole and where inflation falls.

 Inflation is one economic concept that most of us see on a regular basis. It’s the purchasing power of your money, the general increase of the cost of goods and services over a specified period of time. Your dollar that is worth X today will not be worth X five years from now.

Consumer Price Index

One of the best measures of inflation is consumer price index. CPI measures changes in price of a set of consumer goods and services purchased by households. There are eight major groups that include the costs of things like cereal, rent, dresses, gas, prescription drugs, televisions, college tuition and funeral expenses.

The Big Mac index was founded as an informal way to compare purchasing power between different currencies but has been expanded to include the amount of time someone has to work in order to buy a Big Mac.

Demand Pull Inflation

In most cases, we want inflation to increase, but not too steeply. Controlled inflation can erode the cost of debt. Good inflation is known as demand pull inflation and happens during periods of economic growth and increased income. Consumer demand increases.

Wartime is a good example. Who buys a lot during wartime? The government and it buys from the private sector. When a big order comes in to Lockheed Martin, the company hires more workers. More people have money and they too, spend money in the private sector buying cars and homes and electronics.

Cost Push Inflation

Cost push inflation is the “bad” kind of inflation. A good example would be when there is a drought. There is less food available which causes price increases. The producer has to make money but they have less product to sell. So what do they do? They raise the price.

The ongoing drought in California and the water restrictions being imposed because of it, are going to make rice more expensive. California is the country’s second biggest rice producer(who knew!) and will grow 25% less than last year. So your sushi is going to get more expensive.

Federal Funds Target Rate

The federal funds target rate is “the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.” The higher the federal funds rate, the more expensive it is to borrow money. The Federal Open Market Committee meets eight times per year to set key interest rates.

Stagnant Wages

Inflation has been low, but our wages have been stagnant for decades. After adjusting for inflation, today’s average hourly wage has just about the same purchasing power as it did in 1979. Productivity and Gross Domestic Product have increased, but wages for the average worker have not. This stagnation is one of the reasons the Fed has been reluctant to raise rates.

Deflation

Deflation is a drop in consumer prices and measured using the CPI. This sounds like a good thing for consumers but is a sign of a long term decrease in demand and signals that a recession is probably already happening. Manufacturers and sellers of goods start cutting prices and if this goes on long enough, it also means they will cut employee wages or even go out of business entirely.

Disinflation

Disinflation is the slow down in the rate of inflation.

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