In the prior "GDP" course we talked about inflation, but what really is inflation? Inflation is the long term rise in the prices of goods and services caused by the devaluation of currency. Inversely, deflation is the drop in prices of goods and services caused by valuation increase of a currency. You may have heard your parents say something like this before, "$5.00 for a burger! Why when I was a kid it only cost 50 cents" this is the inflation effect, but what causes it?

The Money Supply

Inflation is primarily driven by an increase in the money supply (or in other words: government printing more money) that outpaces a nation's economic growth.

Most industrialized nations have moved away from the gold standard over the past century, which means there is no longer something tangible(real) that backs the value of that money. When the gold standard was used it meant you could in theory go exchange your nation's currency for an amount of real gold. Now the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. The value of money can fall when the Federal Government decides to put more money into circulation at a rate higher than the economy’s growth rate. As a result, this devaluation will force prices to rise due to the fact that each unit of the currency is now worth less.

When a government decides to print new currency, they essentially water down (devalue) the value of the money already in circulation. If you increase the money supply that leads to more dollars chasing the same amount of goods in an economy, which will inevitably lead to increased demand and therefore higher prices(inflation).

The National Debt

We all know that high national debt is a bad thing, just like a high personal debt is a bad thing. So what can a government do to solve it's debt? The government has three options: they can either raise more tax revenue, reduce spending, or they can print more money to pay off the debt.

A rise in taxes will cause businesses to react by increasing the prices of their goods and services to offset the increased tax burden.

Alternatively, printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the nation's currency and increased prices as mentioned above. This is particularly an issue when it comes to personal savings. If you're an individual that saves $1,000 each year for retirement, inflation will make all the past money you saved less and less valuable. This is one of the reasons that most retirement savings go into investment style plans.

Demand-Pull Effect

The demand-pull effect states that as wages increase within an economy, people will have more money to spend on goods and services. With more money in people's pockets this will increase the demand for certain goods and services. As a result of increased demand, companies will likely raise prices to the level the consumer is willing to pay which will balance supply and demand, creating a new equilibrium.

Cost-Push Effect

The cost-push effect states that as input costs like raw goods and materials or wages increase, companies will preserve their profitability/avoid losses by passing the increased cost of production onto the consumer in the form of higher prices.