I do not understand how inflation works if my life depended on it. I understand that it’s an occurrence when you have something in excess amount (like money), thus it becomes worth less.
But why does it become worth less when we give money value? Could we not assign the same value to the same things we have in an excessive amount? Is inflation a law of sorts?
It’s so confusing to me.
In: Economics
Inflation doesn’t “have to exist”, but it’s proven very, very difficult to maintain stability during deflationary times. Even a tiny bit of “stagflation”, where things are even or slightly deflationary, tends to dry up investment money and lead towards depression. So if the region between +1% and -1% is unstable and tends to turn into -5%, then central banks are going to get to +1.5%
It compels people to spend today for fear of higher prices tomorrow. A vibrant economy means money passes from person to person quickly. But If people didn’t spend money or invest to grow their money, the economy would slow and suffer as stores’ sales drop, businesses don’t have access to money to buy inventory or invest in capital expenses (factories, vehicles, etc).
Value is something different than the actual number printed on the bill. It’s an abstract measure of how “useful” something is to us. Nobody decides how much “value” money has. It’s dictated by the ebbs and flows in market forces.
Theoretically we could have zero inflation. We could also have deflation. Steady inflation is not a law. Most western nations intentionally create small amounts of steady inflation, since this drives investment.
Interest is the value of having something now, rather than later.
Say you lend someone $100. You no longer have that $100 to spend. Giving up the ability to spend that $100 now is worth something. You would articulate that by specifying a percentage of the $100 which you think is worth the loss of $100 for that period of time, and agreeing with the lendee that they will not only return your $100, but pay you the interest in return for them being able to spend that $100 now instead of you.
Because no one wants to lend money without getting something in return, interest is rarely negative.
Investments make profit when they earn more interest than other investments. The relative performance determines if you come out ahead, or behind.
Inflation is the incremental price increase of everything as market players try to out perform each other.
It works well, until it doesn’t.
Okay, I’m sure you understand supply and demand, right? Well, one reason for inflation is there is a certain amount of the money supply in circulation to satisfy the demand of a given population.
But the population keeps increasing consistently over the last several decades. So now there is *less* money per person unless you increase the money supply. And if you increase the money supply, you get inflation.
And that’s a good thing. Otherwise, those with vast sums of money could horde it over time since less money would be available for more people, thus increasing their net worth by simply holding on to the cash. BUT if you take that money out of circulation, there is even LESS money, and you get a runaway depression.
**Second**, inflation helps nations pay off huge debts. Since nations don’t think on human lifetime timescales, they can use decades to play with debt. So, if they take out a debt now, inflation can eat away at that debt over centuries even if payments are not made. I’d be like if you took out a loan in 1960 to buy a brand new car for $2,500. That loan then provided a huge service to you, and time would have made the principle a tiny sum by today’s standards. Well, nations can do that since they can think in centuries, not years.
Inflation is merely the product of an increasing money supply relative to the number of goods and services available. In fact, some economists even define inflation as “An increase in the money supply”, with the increase in cost of consumer goods merely being a by-product.
>But why does it become worth less when we give money value?
We don’t “give money value”. The market price of any given good (barring government price controls) is the result of an implicit bidding process. If there are 1,000 units of product A available, then the 1,000 people who are willing to pay the most for the product effectively set the price, since they can outbid anybody who is not willing to pay as much. In practice, with most consumer products, this takes place over a long time, and comes primarily from companies setting a price and then adjusting based on how well/poorly a product is selling.
>Could we not assign the same value to the same things we have in an excessive amount?
The problem with doing that is that you now have a lot of that product going unsold, which doesn’t really help anybody. Prices are an important market signal that tell us what the most socially advantageous way to allocate scarce resources is. Setting them in stone results in overproducing unwanted products and under-producing wanted ones.
>Is inflation a law of sorts?
Inflation is basically just a specific case of the law of supply and demand (the real version, which is much more complex than the commonly understood one).
Back when we had hard money (ie, all dollars were backed by gold), deflation was more common than inflation, since the number of goods and services produced by the growing US economy outpaced the increase in the gold supply. It was only when the government issued a lot of non-gold backed money that the value of the dollar fell.
If you’re feeling adventurous, there are two books you can read which go over price dynamics in very fine, very fundamental detail. They aren’t exactly easy reads, but they’re both written to establish economic theory from the ground up, so they don’t rely on any pre-existing understanding. You can also get free audiobook versions of both:
[Human Action](https://mises.org/library/human-action-treatise-economics-0)
[Man, Economy, and State](https://mises.org/library/man-economy-and-state-power-and-market-0)
“we give money value” doesn’t mean that we decide “money will have x value”. It means that we as a society follow the “rule” that we accept money as payment, meaning that I’m willing to give you my actual product or service (eg hamburger) for your money, because I know someone else is willing to give me beer for that money. Money is a tool that replaces “x for y” trades which are impractical (I have a, want b, you have b, want c, he has c, wants d, she has d, wants a – easy solution, but impractical in real life). Instead of trading 2 burgers for beer, I sell 2 burgers and buy beer. The value are the products and services. If you double the amount of money everyone has, it’s still 2 burgers for a beer. People would want to buy 2 times more things, even though there aren’t 2 times things. And so, sellers would raise price (since they have more customers than product, meaning they don’t care about losing the extra customers). And then all prices rise to a point that they become stable again. If in the past burgers cost 2$, but now people have 2x money, they’ll cost 4 dollars.
The economy can only produce a certain amount of stuff. Prices are the amount of money people are spending divided by the amount stuff of people are producing.
The stuff people produce increases over time. As the years pass, we get better organized, we invent better technology, we build more infrastructure like roads and factories.
If the amount of money people spend increases *just as fast* as the amount of stuff people produce, everything’s fine and prices stay the same: You have the same amount of $ chasing the same amount of goods and services.
Mismatches in either direction cause prices to change. Which is disruptive. But doing an exact match isn’t really possible. Because the amount of money people spend depends a lot on individual decisions, and so does the amount of stuff people produce. And people do lots of transactions involving IOU’s.
So most economists come to the following conclusions:
– Mismatches, changes in prices, and the resulting disruption is unavoidable.
– Therefore we should minimize disruption, while recognizing we can’t eliminate it entirely.
– Prices going up is less disruptive than prices going down. So we should aim for prices to go up.
– Steady, predictable changes in prices are less disruptive. Prices going up 2% each year for 20 years is much less of a problem than prices going up 0% a year for 19 years, and then going up 20% in the twentieth year.
No, inflation doesn’t have to happen. Through most of the nineteenth century, U.K. inflation hovered [around](https://monevator.com/a-history-of-uk-inflation/) zero. Having inflation around 2% or so is a choice governments make.
Other answers have covered this, but the more you have of anything the less it is worth. With money in particular, if everyone had much more money, then they’d be willing to pay more for everything, so the prices would go up. (Think about buying a house – if you had twice as much money, you’d be willing to pay a lot of it for a nice house, right? But you are competing against other buyers, so if everyone has more money, all the house prices go up.) The key bit to grok is that value isn’t assigned by someone, somewhere; it arises out of lots of people bidding against each other for the same things.
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