Welcome to the latest installment of our series! We’ve rounded up experts in the fields of economics and personal finance to answer common questions young people have about their money and the economy. For this column, we’ve asked an expert on economics and finance for his insight on a hot topic in policy circles—inflation. Got a question you’d like to see addressed in this space? Shoot us an email at info@econ4u.org.
Today’s expert is Steven Horwitz, the Charles A. Dana professor of economics at St. Lawrence University in Canton, NY. At Econ4U, we talk a lot about how you spend your money. But how much is that money worth—and who controls it? We asked Horwitz for three things you should know about inflation.
1. Inflation is caused by central banks creating too much money.
People tend to think that inflation is a rise in prices caused by greedy businesses. It’s not. Inflation refers to an increase in the overall level of prices, caused by an overactive central bank that’s creating (or “printing”) too much money and causing prices to rise for all the wrong reasons
For instance, when your local ice cream store slightly raises the price of a single-scoop cone after a record-breaking summer, they’re responding as any business would to an increase in demand for their product. That’s healthy. But if there’s an excess of money in the economy, prices don’t just rise at one store—they rise everywhere, as business owners mistake an excess of money for a change in demand.
2. Inflation harms the entire economy.
Because the excess money created by a central bank doesn’t appear in everyone’s bank accounts at once, some people get to spend it first. One result is that not all prices change the same amount – some go up a lot, some a little, some can even fall.
This makes it hard for entrepreneurs (like the local ice cream store described above) to figure out whether the price changes are due to the inflation or due to longer-run changes in demand or supply. Resources get misallocated, employees are hired or fired unnecessarily, and overall economic growth is reduced.
3. Inflation is often linked to large government deficits and debt.
When inflation is unexpected, it reduces the real burden of debt as borrowers pay back their loans in dollars that are less valuable than the ones they borrowed (because prices are now higher). Of course, the largest borrowers these days are governments; our own is in debt to the tune of $14.5 trillion.
When governments run budget deficits and increase their debt, they face a large temptation to use their central banks to inflate and thereby reduce the real value of their debt. We have seen this happen in other countries throughout history, with disastrous results for consumers as the value of their savings plummets.
