I have never been a fan of economic news, so I don’t have much knowledge about any of it. But I do know one thing about our economy: whenever inflation goes up, our life gets a little more complicated, and if it goes really up, then we tend to get into big trouble. The trouble we usually get into is prices getting too much out of hand and many of us suffering from it. But as I was writing this blog, I did a lot of digging and tried to understand how and why inflation happens and why it is so complicated. I have tried to write it down as simply as I understood.
High Inflation in 2022
“Inflation is causing stress.” “Bad news about prices in the grocery store.” “Historically high inflation.” These are headlines from 2022 when much of the world experienced unusually high inflation rates. The U.S., U.K., and Eurozone all peaked at around 10%, meaning prices were, on average, 10% higher than the previous year. While this may not surprise anyone, inflation rates have since moved closer to normal levels, albeit still slightly high. This does not mean prices have dropped; they are just not increasing as quickly. This situation is stressful for consumers, businesses, and governments alike.
By definition, inflation means a comparison of prices between previous years. If you can buy something for $100 and the price goes up 6% next year and it costs $106, then inflation is 6%. So, because in 2022 the prices went up too much, the inflation went way up and so did the prices. But now, as the inflation did come down, it doesn’t mean that the prices went down. It’s just not getting up as fast as before. So we still have a lot of problems to solve to cover up the 2022 inflation. This without a doubt paints a picture of how inflation is bad for our country.
The Virtuous Cycle of Inflation
Despite its negative impacts, a small amount of inflation is considered beneficial. Many countries aim for an “inflation target,” typically around 2%. This target fosters a “virtuous cycle.” When prices rise modestly, people expect future increases and spend money sooner, especially on big purchases like cars or appliances, to avoid paying more later. This spending boost benefits companies, leading to job creation and wage increases, which sustains consumer spending and economic growth.
This creates a cycle of making the economy better. More people get better jobs and wage increases, more people spend money on things that they wouldn’t have. On the other hand, if the inflation was at 0%, that would mean the price doesn’t go up every year and it is the same. This leads to a different cycle. When the price stays the same for years, everyone tries to keep their money because the price will stay the same, and they don’t need to buy things now. The bank, on the other hand, will give them money if they keep the money in the bank. So they get a better deal out of things. This leads to less and less sales, and companies having fewer sales means people losing jobs, which will make people spend less and less. They will only buy the essentials and things will slow down, and the economy will crumble. This cycle is very dangerous because it can very easily change the economy and make our lives much harder.
Wage Growth vs. Inflation
However, for this cycle to remain beneficial, wage growth must match inflation. In the U.S., wages lagged behind inflation for two years but began to outpace it by mid-2023, especially at the lower end of the wage spectrum. Nevertheless, overall wages remain insufficient, indicating that while wage growth is good, it has not reached adequate levels. This is why everything still seems slow and stuck. Though wages are getting better, the price of things has increased so much that the current wages are not adequate. For example, if someone was getting a $10,000 salary and now, with a 5% increase, receives $10,500, with a 4% inflation rate, they can buy what they could have bought for $100 with $104. But because prices went so high in 2020 and 2022, this small change doesn’t make such a big impact.
Government Tools to Combat Inflation
Governments can combat rising inflation by raising interest rates, making borrowing more expensive, which slows down economic activity. This was the approach taken by the U.S. Federal Reserve in 2022, which helped bring inflation closer to the 2% target but also placed financial strain on families.
The Dangers of Deflation
While high inflation is challenging, deflation—falling prices—can be equally problematic. When prices drop, consumers may delay purchases, expecting even lower prices, which reduces overall spending. This is more problematic because when people see prices going down every year, they think it is failing and try to avoid it more and more. Because sales don’t go up and keep going down, companies have to cut corners to match the market and try to get the prices even lower. To do that, they tend to fire people and cut off many things. When more people lose jobs, the economy fails even more. Businesses get closed, and everyone fears taking any chances and only tries to survive with the most necessary things. This can lead to a deflationary spiral where companies earn less, cut costs, and lay off employees, further reducing economic growth. Historical instances, like the Great Depression, highlight the severe impact of this kind of deflation.
The Role of Inflation Targets
Maintaining slight inflation prevents deflation. Inflation targets act as a buffer against economic fluctuations, keeping the economy from slipping into deflation. Therefore, a little inflation, though annoying, is crucial for economic stability.
Conclusion
Inflation will always fluctuate due to the complex interplay of millions of economic decisions. While zero inflation might seem ideal, it poses risks of slipping into deflation. Therefore, a slight inflation target ensures stability, making “a little inflation” a necessary economic condition. With a small stable inflation rate, a country can make the most out of an economy.
