Inflation: How 'bout Them Apples?

 I recall once hearing that “inflation is when you pay fifteen dollars for a ten-dollar haircut that used to cost you five dollars back when you had hair”. As consumers, we frequently conceive of inflation as a rise in the price of the goods and services we use. That isn't altogether incorrect, but it isn't entirely accurate either. Clearly, prices at the gas pump and at the grocery store are rising, but this isn't because those things have miraculously become more expensive. It is based on the fact that there is more money available to buy the items in question.

Over time, the cost of producing goods and services does increase for various reasons, but inflation primarily stems from a government’s ability to print and distribute money. For example, if a nation can only produce ten apples, and that same nation prints ten dollars, then we can easily see that each apple would cost one dollar.  If that same nation printed an additional ten dollars, then that same apple would now cost two dollars. That is an easy way of understanding how printing excess dollars can lead to an increase in the cost of goods and services passed to consumers.

So, why would a government produce more money if the end result is inflation?

Green Apples

Money supply expansion has been shown to be an effective technique for recovering an economy. The United States has increased the availability of dollars to recover from the 2008 credit crisis. Similarly, when the COVID-19 pandemic was nearing its peak in 2020, the printing of money (given to us consumers) helped the country get through a challenging economic period. Controlling the money supply, when done effectively, is an important instrument for governments to consider when managing an economy.

However, as the increased supply of money results in inflationary pressures, the government must use

another weapon to reduce the flow of currency, namely, raising interest rates. Now, rising interest rates can benefit savers, who now enjoy higher earnings on their CDs, money markets, and savings accounts. But, when interest rates increase, consumers end up spending less. Mortgages become more expensive, as does the financing of a new car. When a nation spends less (and consequently saves more), the available dollars are reduced in the economy. Likewise, a reduction in spending by consumers can result in fewer goods and services being produced. This effect is a slowdown in the market, often including a drop in stock prices and

layoffs at employers.

Therefore, we can see that managing the supply of money is a difficult balancing act that a government must employ wisely for the benefit of an economy. It is during each of these periods (expansion and contraction of the money supply) that we, as investors, must recognize that our goals are long-term and that being diversified in our plan will help navigate our investments through periods of volatility. Finally, we must always remember that these effects on the economy and our savings are naturally occurring and that we have experienced them before (about every three to five years). As before, being diversified and patient will help deliver a successful outcome in the long run.

by Bartt Stevens