The Ultimate Guide to Inflation

Inflation is a major factor in our lives, from foreign exchange to politics and shopping. Although it’s important to know, it’s not always easy to grasp the concept of inflation. Here, we’ll tell you what you need to know.

What is inflation?

You’ve probably heard the term inflation quite a bit, but do you really understand what it is? Read on for a primer.

Inflation is an increase in the price of goods and services. That means that when inflation rises, every dollar you own has less purchasing power. It’s brought on by a number of different factors, including demand-pull, which occurs when demand grows faster than the supply of money, and cost-push, which occurs when companies’ costs go up and they pass them onto consumers. As a result of inflation, banks must vary their interest rates and employers increase wages. Another important result of inflation is the way it changes the value of the dollar.

How does it relate to foreign exchange?

Most currency traders know that inflation is a major factor in forex. But how exactly does inflation influence a currency’s value?

The value of currency is directly related to its buying power. When inflation occurs, that buying power is chipped away. Some rate of inflation is expected, but if inflation rates skyrocket, the currency is weakened. Additionally, when inflation or hyperinflation is brought on by money printed to cover budget deficits, the value of the currency falls because of this added supply. This is a practice that is criticized by many.

How does the Federal Reserve manage inflation?

In short, the Fed exercises power over inflation by adjusting the amount of money in circulation. This is done in a number of ways.

As we’ve noted, the Federal Reserve can print more dollars, increasing the supply and inflating the currency. Beyond that, the Fed can buy or sell US government securities, which either raise or lower the nation’s money supply, or raise the amount of money that commercial banks are required to hold in reserve, which restricts the money supply. Inflation is affected by interest rates as well: by making money more expensive to borrow, consumers are less likely to spend, which can lead to lower prices and reduce inflation.

What does inflation have to do with politics?

Inflation has a major effect on politics in America. The government often wants or needs to spend more money than there is available, and it works with the Federal Reserve to print more money to make up for where the supply leaves off.

This practice of self-inflation has many political and economic critics, and one of the biggest ones today is presidential candidate Ron Paul. He believes that this sort of monetary debasement is a secret tax that hurts consumers by making every dollar they own less valuable than before. Instead of creating inflation, Congressman Paul proposes that we practice smaller government with reduced or eliminated entitlement programs and less costly government intervention in a number of industries, including healthcare.

What’s the connection between inflation and employment?

Inflation and employment are closely intertwined. When unemployment is high, inflation is low, and vice versa. Additionally, employment is the cause of the price-wage spiral that contributes to inflation.

The relationship between employment and inflation is best explained by the Phillips curve. The curve explains that high unemployment rates mean low inflation, and low unemployment rates add up to increased inflation. Today, the Phillips curve exists in a modified state, augmented by inflationary expectations. Essentially, the Federal Reserve has the power to temporarily decrease unemployment by increasing inflation, or increase unemployment by decreasing inflation. Another way employment and inflation are intertwined is through wages. The wages of employed workers have an effect on inflation, which is called the price-wage spiral. The spiral contributes to inflation, and is caused by raised wages due to, you guessed it, inflation. Raised wages create higher costs for businesses, which are often passed on to consumers, and thus perpetuate the spiral with a higher cost of living.

What impact does inflation have on industry?

Inflation makes everything more expensive, driving up the cost of doing business. From wages to goods, businesses have to deal with the effects of inflation on a regular basis.

As inflation increases, so does the cost of living. This means that businesses must offer higher wages, or risk losing valuable employees to competitors that offer more money. With inflation, the value of the dollars a business has to spend is lowered, making purchases of raw goods and services more expensive. Ultimately, this higher cost of doing business makes it harder for industries to be successful in the market, due to consumer pushback against higher prices, and lowered competitiveness against foreign suppliers.

How does inflation affect consumers?

It’s easy to regard inflation as an abstract concept that has little affect on your daily life, but the fact is that inflation has influence on everything from overseas travel to grocery shopping. Take a look at just a few of the ways inflation impacts consumers’ lives.

If you’ve ever traveled overseas, you’re familiar with the impact exchange rates can have on your spending. When inflation occurs, and the dollar is devalued, your purchasing power decreases against other currencies. Inflation has an effect on purchasing power at home, too. As we’ve noted, industry is affected by inflation, driving up costs that are passed on to the consumer. As a result, inflation makes everything more expensive, whether you’re shopping for a car or just buying a DVD. On a larger scale, when inflation is paired with low interest rates, it can create increased spending, such as that we’ve seen recently in housing. Because of a low cost to borrow, consumers flocked to the housing market, inflating home prices.

When looked at in detail, it’s clear that inflation has far-reaching impact on not only consumers’ daily lives, but interests in industry, politics, and beyond. Inflation is an issue that currency traders should keep a close eye on as the dollar struggles against other world currencies.