Inflation is defined as an increase in prices and/or a fall in the purchasing power of money. Simply put, if prices go up or the value of your money erodes, you’ve got inflation on your hands. We’ve seen this a LOT in the past few years, as the prices of virtually everything have gone up.
So what causes inflation?
Two main things: adding more money into a situation and adding costs to a situation.
Let’s start with adding money into a situation. We often hear that when the government prints more money, inflation happens. This isn’t wrong, but it’s not the whole picture. You can also add money into a situation by making more money available to buyers. This is primarily done via loans. Student loans and mortgages are two of the largest drivers of this. Let’s say that you want to go to college but student loans don’t exist; you have to pay upfront for it with the money you currently have saved up. Chances are, you can only afford to pay a few thousand dollars or so. Most people are in a similar situation, so colleges start charging $2,000 so that their customers can afford to attend.
Now, a few businesses and government groups get together with the colleges and discuss how they can make it easier for people to attend college. They realize that some people can’t afford to shell out $2,000, so they decide to loan people the money for college and let them pay it back over time so that they can spread out the payments into smaller pieces. Rather than paying $2,000 upfront, you can borrow $2,000 and pay it back over the course of 5 years (plus interest). All of a sudden, the people who couldn’t afford the $2,000 can afford it. However, the people who could afford it before can now afford to pay $4,000. The colleges realize that these people can afford the higher tuition, so they raise the price. The colleges realize that they just doubled their income without having to make any real changes, so they are ecstatic. They go to the government and the bankers, who are happy to be bringing in the interest income from the loans, and they try to think up a way to increase their income. They realize that if they spread out the payments over 15 years instead of 5 years, their customers can afford to borrow and shell out even more money. The colleges raise their tuition to $9,500/year, and the banks and government loan the money to everyone so that they can keep paying for school. The best part is that because you’re spreading out the payments more, your monthly payment is essentially the same as it was when you were paying $4,000/year! (You are, of course, making that payment for 180 months instead of 60 months, so you’re paying more in the long run).
Mortgages work pretty much the same way, except the housing market is even more responsive to changes in mortgage terms than the education market is because homebuyers are trying to outbid each other for houses every day, whereas colleges raise tuition more gradually. However, the end result is the same; when you give people access to more money, prices tend to go up.
One of the big ways that people access more money via loans is when interest rates are lowered. When interest rates fall, people can afford to borrow more money because they are paying less for every dollar that they borrow. This is the big reason why we tend to see inflation rise when rates are low and fall when rates rise, and why interest rates are used to help keep the pace of the economy fairly steady. When people aren’t spending money, the Federal Reserve can lower interest rates to encourage more spending, and when inflation starts to get too high, the Fed can raise rates to get people to cool their spending a bit, which trickles into the other areas of the economy and brings things back to a more manageable state.
The amount of money people spend is one of the biggest drivers of inflation, but it is not the only one. As you’ll see in this series, inflation is a messy web of interconnected factors that feed off of each other and cause loops that push the inflation rate violently in one direction for a long time, and then do a full 180 and reverse as just as violently.
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