In today’s global economy, fears of inflation are front and center for many. This fear is driven by massive government stimulus in response to the COVID-19 pandemic. However, many market participants nowadays haven’t experienced truly unhealthy levels of inflation and therefore aren’t prepared to protect themselves against it. In order to understand where this fear originates from and

how one can better protect themselves from unhealthy levels of inflation, it is paramount that market participants and everyday individuals understand the ins-and-outs of inflation. In this report we break down inflation, elaborate on its causes and effects, discuss how central banks manage it, explain what it means for society, and lend insight into how anyone can protect themselves against it.

 

What Is Inflation?

Inflation is an economic term that refers to a general rise in the price of goods and services in an economy. A rise in prices causes fiat currencies to lose purchasing power. Central banks measure inflation by calculating the rise in the average price of a basket of goods and services. Because prices are a function of supply and demand, all else being constant, an increase in the money supply (i.e., greater demand) can increase the general prices of goods and services. 

 

The inflation rate is a proxy for understanding how much the average household’s cost of living rises per year. Inflation attempts to quantify how much more it costs to buy everyday goods, such as gas, groceries, hygiene products, and other common consumer goods costs relative to how much they cost in the past. Inflation seems harmless when under control. However, it causes an insidious drain on the wealth of the consumer and is catastrophic to an economy when unmanaged. Former US President Ronald Reagan once famously said, "Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly

as a hitman."

 

Causes of Inflation

In times of uncertainty or hardship, like an economic recession, consumers don’t spend like they usually do and instead opt to save. This behavioral shift is because they expect a potential loss in consumption ability (e.g., losing a job or falling real wages). However, there are knock-on effects: if consumers aren’t spending, business production declines, employees are laid off, and people make fewer investments. These effects can create a vicious cycle that central banks often try to mitigate by increasing the money supply to stimulate consumption and investment. By pumping more money into the economy, consumers will have the confidence to spend

more in businesses that, in turn, can invest in new or existing products and services. Thus, central banks reinvigorate economic activity to attempt to jumpstart economic growth. Central banks measure this growth in Gross Domestic Product (GDP), or the total value of all goods and services a country produces in a given year.

 

Inflation is usually a direct result of central banks creating money faster than GDP growth. However, this imbalance doesn't always lead to inflation: money can enter circulation without causing inflation. For example, increased investment enables technical innovations that are generally deflationary (i.e., causes prices of goods and services to fall); when businesses can produce goods and services at a lower cost and faster than consumers can demand them, prices fall. In other words, new money is not always

frivolously spent. Some may save or pay down debt. Even though the money supply is greater than before, the velocity of money fell (i.e., the rate at which money is exchanged within an economy).

 

The Triangle Model

The three root causes of inflation, or what the Keynesian economist Robert J. Gordon termed the "triangle model," are demand-pull inflation, cost-push inflation, and built-in inflation.

 

Demand-Pull Inflation

When the demand for goods and services rises faster than productive capacity, demand-pull inflation occurs. This type of inflation is due to an increase in the supply of fiat currency and cheap credit. As more money is put into circulation and is easily accessible, both demand and prices rise. For instance, if demand rises by 5% while productive capacity is only growing by 3%, demand will

outpace supply by 2%. With more money chasing fewer goods and services, prices will naturally rise. Demand-pull inflation has occurred many times throughout history.

 

And much, much more!

 

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