Inflation, You Feel It, Do You Understand It?

The textbook definition of Inflation is the general increase in the prices of goods and services over time, which decreases the purchasing power of money. This phenomenon is not about the cost of a single item but about a widespread rise across the economy, driven by factors such as increased consumer demand, higher production costs, or an expanding money supply. Inflation is typically measured as a percentage change in price indexes, such as the Consumer Price Index (CPI).

However, Friedman places most of the blame for inflation on the government's printing more money and injecting it into the economy, thereby reducing its value. In one of his videos, he compares inflation to alcoholism.

As Friedman explains, at first the effects may appear sound, but over time they become negative. Governments "produce" more money, typically through their central banks, to stimulate economic growth, encourage spending, lower interest rates during recessions, or manage crises such as the 2008 financial crash or the COVID-19 pandemic. This is often done by purchasing bonds in a process known as Quantitative Easing, which injects liquidity into the economy. However, if this is done excessively without a corresponding increase in economic output, it can lead to inflation and devalue the currency, as Friedman explained, you then have "too much money chasing too few goods."

Inflation is not just generated by printing more money. Central banks (such as the U.S. Federal Reserve) create money digitally, not only in paper form. They purchase assets (such as Treasury bonds) from banks, thereby increasing banks' reserves with new money. Banks then lend these funds, multiplying the money supply.

A small amount of inflation is normal and manageable in a growing economy

If money increases faster than goods and services, prices rise because people have more money to spend on the same amount of products. Hyperinflation occurs when excessive money printing renders currency nearly worthless, as seen in historical examples such as Weimar Germany. This can also cause devaluation, which is a loss of confidence in the currency’s value.

Here's a straightforward example: In 1913, a gallon of milk cost approximately 36 cents. By 2013, the price had risen to $3.53. This increase isn't due to a more complicated production process for milk today than it was a century ago. Instead, it's because the money supply has grown significantly, leading people to demand more dollars for the same products in order to keep pace with the general rise in prices.

A small amount of inflation is normal and manageable in a growing economy. Moderate growth in the money supply is necessary to ensure that people have enough cash to buy and sell the new goods and services being produced. However, high inflation can disrupt the economy. Borrowers benefit from high inflation because they can repay their debts with money that has less value. On the other hand, creditors are disadvantaged because they receive repayments in dollars that are less valuable.

Under the Biden administration, inflation has led to a cumulative 20 percent increase in the Consumer Price Index. Although the inflation rate has decreased to 3.0 percent, overall prices have not returned to pre-2021 levels. Achieving that would likely require a considerable economic slowdown or recession. Some prices have decreased, with recent declines in oil prices and fuel costs attributed to increased oil production.

Although the rate of price increases has slowed, the overall price level continues to rise. As a result, the loss of purchasing power has not been offset by increases in real income.

The Federal Reserve and most central banks believe that 2 percent annual inflation is the "sweet spot" to encourage spending without eroding savings too quickly or risking deflation. Naturally, consumers prefer lower inflation, with surveys showing preferences closer to 0-1 percent. In essence, the acceptable rate balances economic growth with price stability, with 2 percent widely regarded as the benchmark for a healthy, growing economy.

During President Trump’s first term, the inflation rate averaged 1.87 percent annually. 2017-2.1 percent, 2018-2.4 percent, 2019-1.8 percent, 2020-1.2 percent for a cumulative total of 7.5 percent.

During Joe Biden’s term, the inflation rate averaged 4.93 percent annually, more than twice the acceptable rate. 2021-4.7 percent, 2022-8.0 percent, 2023-4.1 percent, 2024-2.9 percent for a cumulative rate of 19.7 percent.

The key point is that government fiscal policy plays a crucial role in both causing and controlling inflation. Government actions, such as spending and taxation, along with monetary policy—managed by central banks like the Federal Reserve through interest rates and money supply—are significant factors in influencing inflation.

For example, substantial government spending can increase demand (known as demand-pull inflation), while central banks may raise interest rates to cool down an overheating economy. This illustrates the government's direct influence on maintaining price stability.

I hope this helps with understanding inflation. At least you now know that the government benchmark is 2 percent. That’s considered a sign of a good growing economy. It also means that your earning capacity should increase by at least that amount to keep pace under ideal conditions.