The law of supply and demand, briefly, states that when demand is high, prices will rise, and when supply is high, prices will drop. Two examples demonstrate this. If there is a theater with 2,000 seats (a fixed supply), the price of the performances will depend on how many people want tickets. If a very popular play is being performed, and 10,000 people want to see it, the theater can raise prices so that the richest 2,000 can afford to buy tickets. When the demand is much higher than the supply, prices can go through the roof. Our second example is more whimsical. Let's say you live on an island where everyone loves candy. However, there's a limited supply of candy on the island, so when people trade candy for other items, the price is fairly stable. Over time, you save up 50 pounds of candy, which you can trade for a new car. Then, one day, a ship hits some rocks near the island, and its cargo of candy washes ashore. Suddenly, 30 tons of candy are lying on the beach, and anyone who wants candy can just walk to the beach and get some. Because the candy supply is far greater than the demand, your 50 pounds of candy is all but worthless.
You may have heard an older person talk about how different things were when he or she was your age. It only cost a nickel to see a movie. Gas was 30 cents per gallon. A brand new car only cost about $5,000. In the intervening years, prices have risen, sometimes drastically. Seeing a movie in the theater now costs about $10; gas costs more than $2 per gallon; and few new cars cost less than $15,000. That's inflation.
Inflation is when a certain form of currency starts to have less value over time. Mainly two things cause it: people's perception of value, and the economic principle of supply and demand.
We have already examined some of the ways that people's perceptions of a currency's value can affect its value. This effect causes inflation by directly affecting the value of the money. When currency was still on a gold standard, inflation often happened when people started to worry that the government or bank wouldn't be able to redeem their cash for gold. If you had a dollar that was worth an ounce of gold, but people thought the government only had half of the gold required to redeem it, then dollars would start being traded at a value of half an ounce of gold. Understanding that the value of money is based on our perception of its worth is easier if we look at how that perception can alter the specific amount of that value. Let's say that one American dollar is worth 5 French francs. One day, the U.S. government announces that part of its economic policy will be to allow the value of the U.S dollar to decrease slowly to about 3 francs (the U.S. government might do this to encourage foreign investors, among other reasons). The next day, the value of the dollar would likely drop sharply, which it has in similar situations. Why? The government announcement led people to believe that their dollars would be worth less -- therefore, they were worth less. The same effect can be seen in today's stock market, which is another currency system. When a company declares that its profits are down, the value of the company's shares can drop within minutes.
Supply problems have had far more dramatic inflationary effects. Throughout history, governments have tried to solve financial problems by simply printing more money. This can drive the value of money drastically downward, especially in modern markets where money is not backed by gold. Twice as many dollars in an economy makes those dollars worth half as much.
After World War I, Germany was forced to pay war reparations of about $33 billion. It was virtually impossibly for the nation to produce that much actual output, so the government's only choice was to print more and more money, none of which was backed by gold. This resulted in some of the worst inflation ever recorded. By late 1923, it took 42 billion German marks to buy one U.S. cent! It took 726 billion marks to buy something that had cost just one mark in 1919.
Here are some interesting links:
- How Currency Works
- How Banks Work
- How Recessions Work
- How The Fed Works
- Understanding Inflation
- Inflation Calculators