How Inflation Works


The Danger of Inflation and How to Control It

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

  • Investments lose value. If you invest in a CD with a yield of 4 percent, but inflation rises at 3 percent, then your return in "real dollars" is only 1 percent.
  • Lenders raise interest rates. If a bank expects inflation to rise, it will charge a higher interest rate on its loans to make up for the loss in dollar value.
  • Fixed incomes erode. If you receive a pension or other fixed annuity in retirement, the payments may not increase with inflation. Social Security payments, however, automatically rise with the latest CPI figures.
  • Businesses have a hard time planning for the future. When the rate of inflation is uncertain, manufacturers and retailers have a hard time determining the future cost of materials and labor. This discourages investment and economic growth [source: New York Fed].

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:

  • The Fed buys from or sells bonds to banks, paying them cash for securities. Buying bonds increases the money supply; selling decreases it.
  • The Fed lowers the reserve requirement, the percentage of customer deposits that banks cannot lend out to other people. The lower the requirement, the more money can be in circulation
  • The Fed lowers its discount rate, the rate its charges banks for short-term cash loans. When banks pay less for a loan, they can turn around and lend the money at a lower rate. Lower rates encourage businesses and people to take out more loans, adding money to the economy [source: New York Fed].

In 2012, the Fed for the first time set a target of 2 percent for the inflation rate [source: Spicer]. At the end of 2012, inflation was 2.1 percent. As of March 2013, the Fed was still committed to buying bonds and keeping its interest rates near zero until the jobless rate falls to 6.5 percent and as long as inflation does not go beyond 2.5 percent [source: Da Costa and Spicer].

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 four dollars? 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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Sources

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  • Board of Governors of the Federal Reserve System. "How will the Federal Reserve ensure that the size of its balance sheet won't lead to excessive inflation?" April 27, 2011. http://www.federalreserve.gov/faqs/money_12852.htm
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