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Understanding Inflation: Why Price Increases, Impact on Daily Life, and the Role of the Fed (June)

Updated: Jul 5, 2023

Mr. Fan Yang, Ph.D. Economics candidate

© International Foundation for World Freedom

Have you ever wondered why prices keep going up over time? Why does it cost more to buy everyday items now compared to a few years ago? The answer lies in a concept called inflation. In this article, we will take a closer look at what inflation is, why it happens, and the effects it has on our lives. We will also explore how the Federal Reserve controls inflation and plays a crucial role in maintaining a stable economy.

What is Inflation

What is Inflation? Inflation refers to the general increase in prices of goods and services over time. It is typically measured as the percentage change in the average price level of a basket of goods and services in an economy. It means that, on average, things tend to get more expensive as the years go by. When inflation occurs, each dollar you have in your pocket buys a little bit less than it did before.

Why Does Inflation Happen

There are several reasons why inflation happens. One of the reasons is the increase in the cost of producing goods and services. For example, if the price of raw materials like wood or steel goes up, the companies that make furniture or cars may need to charge more to cover their expenses. Another reason is changes in the money supply and monetary. When there is too much money in circulation relative to the available goods and services, prices tend to rise. For example, if the central bank prints more money to stimulate the economy, there is a higher risk of inflation as more money chases the same amount of goods and services.

Effects of Inflation

Inflation can have both positive and negative effects on an economy. Moderate inflation is generally considered healthy for economic growth as it encourages spending and investment. However, high and unpredictable inflation can erode the purchasing power of money, reduce the value of savings, and create uncertainty in the economy. Inflation can affect different aspects of our lives. Here are a few ways inflation can impact us:

  1. Purchasing Power: As prices rise, the purchasing power of money decreases. This means that the same amount of money can buy fewer goods and services. For example, if you live in a rented apartment or house, inflation can impact your monthly rent. Let's say that last year, your rent was $1,000 per month. This year, due to inflation, your landlord increases the rent to $1,100. You would need to allocate more money from your budget to cover the higher rent.

  2. Savings: Inflation can diminish the value of money over time. If you save money in a piggy bank or a savings account, its purchasing power may decrease in the future. Let's say you have $100 saved in a bank account earning 1% interest, but inflation is at 4%. In one year, your savings will increase to $101 due to interest, but the prices of goods and services will also rise by 4%. So, even though you have more money, it can buy less than it could before.

  3. Wages: When inflation rises faster than wages, the purchasing power of workers' income decreases. For example, if your salary increases by 2% in a year but inflation is at 4%, you are effectively earning less in terms of what your money can buy.

Why does Fed care about inflation

The Federal Reserve, along with other central banks, was created to promote economic prosperity and the well-being of society. One important task assigned to the Federal Reserve by Congress is to keep prices stable, meaning they want to prevent prices from rising or falling too quickly. The Federal Reserve considers an annual inflation rate of around 2 percent to be ideal.

To control inflation, the Federal Reserve uses interest rates as a tool. When inflation is too high, they raise interest rates. This makes borrowing money more expensive, which discourages people from spending and reduces overall demand for goods and services. By slowing down economic activity, the Federal Reserve can help bring inflation back to a more manageable level. Higher interest rates also encourage people to save money and can strengthen the domestic currency, which makes imported goods cheaper and further helps keep inflation under control.

On the other hand, when inflation is too low, the Federal Reserve lowers interest rates. This makes borrowing money cheaper, which encourages people to spend and boosts overall demand. By stimulating economic activity, the Federal Reserve can increase inflation and prevent prices from falling too much.

By adjusting interest rates, the Federal Reserve aims to maintain a balance between stable prices, economic growth, and a healthy financial system.

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