Inflation: What It Is, Where It Comes From and How It Can Bite You

Inflation has many faces.

For William C., 17, it is the sky-high price of gasoline.

For Joanne I., 17, it is the rising cost of arts-and-crafts material.

For Alan W., 17, it is the market price of meat and vegetables in China, where he has been traveling this summer.

Inflation is all these things and more. “It’s a general increase in the price level and affects everything from school lunches to the price of movie tickets,” says Joanne, a June graduate of West Windsor-Plainsboro High School North in New Jersey who plans to attend Princeton University this fall. Joanne captained the West Windsor-Plainsboro North team that won the High School Fed Challenge championship for the New York Federal Reserve region a few years back. Fed Challenge teams analyze current economic conditions and recommend a course for monetary policy.

Eroding the Purchasing Power of Money

Inflation can be good or bad, depending on how fast the price level rises. A moderate increase of 1%-to-2% a year generally does little harm to the economy. But when inflation really takes off, it hurts people and businesses by eroding the purchasing power of money. Consumers rush to buy things before prices climb higher, which makes them rise even faster. Inflation is especially hurtful to retired people on fixed incomes who can’t hope to keep up with the rising cost of living.

Inflation can happen for a number of reasons.

• Economists known as monetarists believe that inflation is caused by overexpansion of the money supply. This means that the Federal Reserve, the country’s central bank, creates more money than the economy needs for steady growth, and this excess leads to higher prices.

• Another explanation is “demand-pull,” in which the demand for goods and services outpaces their supply and pulls up the level of prices.

• Still another cause is “cost-push,” in which the rising cost of commodities like oil pushes up other prices.

The most painful outbreak of U.S. inflation came in 1979, when the rate hit 13.3% as measured by the Consumer Price Index (CPI), a market basket of hundreds of goods and services that fall into such categories as food and beverages, housing, apparel, transportation and medical care. The U.S. Bureau of Labor Statistics (BLS) computes the CPI by measuring monthly price changes for the items in the basket.

In extreme cases, called hyperinflation, prices rise so fast that money becomes virtually worthless. That happened in Germany in 1923 when the government printed so much currency that it took 140 billion marks just to buy a loaf of bread, according to the textbook Essentials of Economics by Harvard University economist N. Gregory Mankiw. German workers were paid twice a day and had to rush to stores to buy things before prices rose even higher. “If you didn’t get lunch right away you couldn’t afford it,” says Raman M., a teammate of Joanne’s who has studied hyperinflation and plans to enroll in Rutgers University this fall.

Higher Gas Prices, Fewer Video Games

When inflation spikes, it is often caused by high energy prices, like gasoline. A surge in the cost of gasoline can take a toll on people’s wallets. “When you’re filling up a car and working at a minimum-wage job, a 30-cent-a-gallon increase is huge,” says William C., a recent graduate of Ridgefield High School in Connecticut who plans to attend Cornell University this fall. “Kids don’t want to drive as much and are much less willing to go to the movies,” says Craig, whose team was a one-time New York region finalist in the High School Fed Challenge. And with less money to spend on things besides gas, “they’re not going to buy new video games” either.

Inflation can spread from one country to another by jacking up the cost of goods and services that nations trade with each other. For example, when China’s inflation spiked in recent years, the soaring price of pork forced the country to release frozen pork from a reserve that it keeps to help contain prices. The sudden outbreak of inflation could boost the cost of everything from clothing to computers that the United States imports from China. “It’s a very real possibility due to the heavy flow of trade between the two countries,” says Alan W., a teammate of William’s at Ridgefield High who plans to enter Dartmouth University this fall.

However inflation is caused, a standard remedy is for central banks like the Federal Reserve to raise interest rates — the rates at which you borrow and lend money — by tightening the money supply. “That, in turn, would slow down the amount of credit that is being loaned out because people couldn’t borrow as cheaply,” notes Raman, who is 17.

The Federal Reserve monitors the inflation rate closely and either raises or lowers interest rates, depending on what the economy needs to be healthy. In the meantime, our wallets may feel the spike. Inflation is an important economic indicator for consumer decision making.