How Inflation Works

Inflation can hurt people and the broader economy in a number of ways:

In rare and serious financial crises, hyperinflation can set in. In the Weimar Republic of Germany, the mark exploded from 2,000 marks to the U.S. dollar in December 1922 to 4.2 trillion marks to the dollar in November 1923 [source: Jung]! Similar cases of hyperinflation struck China in the 1950s, Argentina in the 1980s, and Brazil in the 1990s, causing massive financial losses and social unrest [source: New York Fed].

After the U.S. experienced double-digit inflation in the late 1970s and early 1980s, the Fed took a more assertive role in controlling inflation through monetary policy. If economic growth is slow, the Fed tries to stimulate the economy by injecting more cash and credit into circulation. Contrary to popular belief, the Fed doesn't "print money" [source: Task]. Instead, the Fed influences the money supply in three major ways:

Author's Note: How Inflation Works

If you are 30 or older — like some of us — then you have caught yourself saying things like, "A gallon of gas is almost $4? I remember when it was $1.25!" I call these grandpa (or grandma) moments. In our exasperation, we fail to account for the long-term effects of inflation. And in our refusal to acknowledge that we are indeed getting old, we forget that two decades have passed since gas prices were that low, or that $1.25 didn't feel particularly cheap back in 1993. What I'd like to know is the exact age at which we psychologically imprint prices. We use this internal reference point to compare prices for the rest of our lives. Maybe it's the year that you first start paying for things yourself, like gas. Or the first time you get a paycheck and realize the true value of money. Soon enough, we all have our first grandpa moment.

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