What Is Inflation?
Inflation is an increase in the price of goods and services not due to growing demand or shrinking supply for those goods and services (which also affects price) but due instead to the dollar losing its buying power. For example, if the annual inflation rate is 10 percent, then a box of cereal that cost $4.00 last year would sell for $4.40 this year, up 10 percent from the year before. In this example, the demand for cereal has not gone up, nor has the supply of cereal gone down; this cereal just costs more because the dollar is worth less. As someone once said, “In inflation, everything gets more valuable—except money.” Actually, nothing gets more valuable, everything just costs more. Prices go up because the buying power of the dollar goes down.
What Causes the Dollar to Lose Buying Power?
For those of us who are relatively new to the sometimes unfathomable world of economics, it may come as a bit of a surprise to learn that the dollar’s buying power or value comes from the very same economic forces that set the value (or price) of everything: supply and demand. For example, if a lot of people want to buy diamonds (big demand) relative to how many diamonds are available (small supply), then the price of diamonds is high. On the other hand, if diamonds were to become as plentiful as, say, sand grains on a beach (big supply) or if people become less interested in owning diamonds (small demand), then diamonds would become far less valuable. It’s hard to think ...