So I went to In-N-Out Burger (my fav by the way) the other day with my dad and ordered 2 veggie burgers, fries, and a glass of lemonade. The total bill ~ $10. Had I have been alive in 1948, that same meal at the same exact place could have been had for a grand total of 75 cents. So how and why do prices for the same exact stuff rise by so much? That’s due to inflation which is increase in the prices of a lot of the goods and services we buy everyday. A dollar less than a century ago could buy much more than it does today and that will likely continue in the future.
But why does this happen? Well just imagine what it would be like if we had the opposite of that and that is deflation. If the prices of goods and services fell every year instead of rising, you’d wait to buy whatever you were in the market to buy because its profitable (for you) to wait. You’ll be able to buy the same stuff cheaper tomorrow or next month or next year than today. So it’s great for you but if everyone started doing this, the overall demand for stuff in the economy will fall. If demand falls, businesses that provide us with those products and services will see their revenues and profits fall. That would then lead them to cut expenses with their biggest expense being people. So people will start losing jobs and no job means no income and no money to spend. So the demand reduces even more and the cycle continues downhill until deflation is countered.
A prime example of what deflation could do to an economy is Japan. Since the bursting of the twin real estate and stock market bubbles in 1989, the economy hasn’t been able to recover. The country is currently stuck in a deflationary spiral ever since where fewer jobs are causing the demand to stagnate with folks delaying the purchase of stuff. Less number of jobs also causes the population to decline because without a job, supporting a family becomes a challenge and hence folks are delaying marriage and having fewer babies. That adds to a further reduction in demand. And when goods are produced at the same rate and the demand is falling, prices drop and the deflationary environment continues.
Something similar occurred in the United States post the stock market crash of 1929 where a lot of people lost a lot of money, banks closed down, and the entire financial system came to a standstill. Businesses started shutting down, laying off workers setting that process of deflation in motion. Spending in the economy just didn’t stop because of people losing jobs but even the fear of losing jobs caused the rest of the people to shut their wallet tight, further reducing demand. That’s what John Maynard Keynes described as the Paradox of Thrift where it’s great in the long run if people saved money but if they do it all at once, things can get real bad real fast.
So now we know why we don’t want deflation but what about inflation? Prices of goods and services rise over time but why? That’s because inflation in an economy is sort of intentional and is designed in by the central bank of a country (the Federal Reserve for example in the U.S.). The central bank of a country controls the money supply in such a way that there is always a little more money in the system chasing the same quantity of goods and services in an economy. What does that do? It causes prices to rise by just enough so that demand for stuff in an economy is always present. And because stuff gets more expensive over time due to inflation, people will not wait to buy what they need for better prices tomorrow or next month or next year. This keeps the businesses busy producing the stuff people need, employees employed and economy stable.
So now that we know that inflation is going to be ever present, how do we make sure that it doesn’t hurt us? I mean how do we keep our purchasing power intact over time so we can buy the same amount or more stuff tomorrow, next month and next year. Inflation rate in the U.S. has historically averaged at around 3% so if we want to make sure that we can buy the same amount or more stuff, we will have to earn more than that over time. Depositing our savings in a bank could be one way but banks don’t usually pay interest more than the rate of inflation. So a better way would be to invest our savings into investments that tend to outpace the rate of inflation over time. And that in theory means owning stakes in businesses that produce the stuff we buy and consume.
For a perfect and well-balanced economy, we don’t want deflation or hyperinflation. Instead, we want something like a goldilocks economy where the prices of goods are not dropping like crazy and not skyrocketing like mad but just right.
Until later.