REVISITING INFLATION
What is Inflation?
We’ve all experienced price inflation. It’s when the price of something you buy gets more expensive year after year. For example, many experience this with their healthcare insurance. Next time you go to renew your plan you may see that the same exact service has risen in price 10-20% from the previous year. Now imagine this occurs with everything you purchase: your rent, your car, your groceries, everything will all rise 20% next year. This means that every dollar you have is now worth 20% less next year, or in economic jargon has 20% less purchasing power. This would be bad if you had saved up a lot of money because it would all quickly start to become worth less and less. Perhaps you would try to spend your money faster so its value doesn’t deteriorate, and this rush of spending would fuel even higher inflation in a feedback loop.
Is the inverse better?
What if prices we’re going down every year not up, a term labeled deflation. You’re initial reaction, unless you are a business owner, is probably: sounds great! But if people expect prices to drop, they’re likely to hold off on spending today and wait for the lower price tomorrow. They are also less likely to borrow money because they would have to pay back dollars that are worth a lot more tomorrow. They’d even be less likely to invest as cash itself becomes an ‘investment’ since it’s purchasing power rises. Companies start to see lower revenue and have higher “real” debt burdens and eventually would be forced to lay people off or worse, close shop. The feedback loop would be lower purchasing power slowing the economic machine and the weak economy feeding further deflation.
So what gives?
Price inflation is clearly interconnected with many other economic variables:
Spending / Saving / Investing / Borrowing
Employment / Unemployment
Interest rates
Money supply
So much so that one of the Federal Reserves dual mandates is to stabilize inflation around a target rate. Economists in general believe that inflation, in moderation (roughly 2%), is a good thing and certainly a lot better than deflation. The idea is, that a good, growing economy will have some level of price appreciation and thus more companies attaining higher revenues and profits, needing to employ more people.
The Phillips Curve
Named after William Phillips who described this relationship between inflation and lower unemployment in 1958
The Phillips curve has been one of the most influential economic models of all time, specially in regard to shaping monetary policy. Both of the two federal reserve mandates pertain to the Phillips curve. The model essentially states that high inflation leads to low unemployment and vice versa. However a lot has changed since 1958. Our economy and the types of goods and services that shape it are drastically different. Our exponentially rapid advancements in technology are inherently deflationary. While its true that the latest and greatest cell phone models may cost upward of $1000 but last years model, which is still a supercomputer in your pocket can be had for a fraction of the price. The same can not be said for eggs or dish soap. But again it can be said of televisions. Technology has changed the game, and its even called into question the methods by which we calculate inflation.
Conclusion
Economists need to revisit these connections of economic variables, who’s causal relationships were argued about and contested even before technology reshaped our world. Whether we like it or not inflation may actually be hard to come by though naturally occurring economic cycles, and most likely will require monetary and fiscal policy. Should it be forced? Hard to say.
If inflation stays low due to downward pressure from technology, and yet unemployment stays similarly low, a phenomenon that’s arguably already been occurring over the last decade, this would be a break in the phillips curve. Now if the curve can break in one direction, it is easy to imagine it breaking in the opposite: High Inflation and High unemployment, a scenario called stagflation. Could this be caused by overextending the money supply and zeroing out interest rates? We’ll have to remain on high alert for it’s signs. 2020 has been an interesting year, and much economic insight will be gleamed once the smoke clears.