How to explain inflation in simple terms #worldfinanceweds

How to explain inflation in simple terms #worldfinanceweds

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Written by Karl Eaves, Public policy nerd, amateur history buff.

 21 Jan 2015

There are two types of inflation.

Demand Pull.

Supply Push.

Demand pull happens there is excess demand of a scarce good.  There are 10 kids who all like balloons.  The Balloon salesman only has 5 balloons.  Each kid has $2 dollars.  The balloon seller advertises that balloons are $1 each.  All ten kids clamour for the balloons, so the seller realises that he can get more for his balloons and puts the price up to $2 (or alternatively, he sells all five and the five balloonless kids offer the kids with balloons $2 for their balloons). The $1 increase is a dollars worth of demand pull inflation.

Supply push happens when the cost of the factors of production increase and sellers need to put (or push) their prices up to continue to make a profit (or in some cases break even or even lose some money, but that’s for another day).  The balloon seller phones his compressed air tank salesperson who explains that due to an increase in the cost of air, he is now selling full tanks for $100 instead of $80.  The Balloon seller knows he gets 200 balloons from each tank, and that the $20 increase means to make the same profit, he now has to sell his balloons for $1.10 instead of the previous $1.  The $0.10 cents in $0.10c of supply push inflation.

That’s the basics.  Then onto the fun stuff.

Then there are inflationary (and deflationary) expectations.  These, in a lot of respects, are more important than inflation itself.  If you are expecting 12% inflation, then you adjust your prices accordingly.  For example, when you lend out money, you add a 12% premium on top of your expected return (so you don’t lose purchasing power over the life of the security).  Or closer to home, if you expect 12% inflation and you sell goods on a 60 day invoice, you add 2% to the invoice price (12% p.a. = 1% per month – kind of, lets ignore compounds for the moment).  If you’re arguing for a wage rise, and you expect 12% inflation, then that’s your starting point for arguing for a 15% pay rise.

When everyone in an economy is expecting 12% inflation, they all adjust their prices upwards by 12% every  year and this acts as a self-fulfilling prophesy.  This is what happened in the 1970’s and early 1980’s.  Everyone expected double digit inflation and so they automatically factored that into their wage/price bids.  When significant inflationary expectations are allowed to develop and continue in the absence of economic growth, or during periods of low growth, this is known as Stagflation (Stagnant economic growth with Inflation.)

Central banks try to limit inflationary expectations by transparently stating that they have a target inflation rate of between 2-3%.  This is generally the agreed sustainable and healthy level of inflation.  It isn’t high enough to erode liquid cash quickly, and it is high enough to provide a useful buffer before deflation occurs (and deflation is a pretty nasty business).

If inflation changes by more or less than inflationary expectations then there are winners and losers.  Say inflation turned out to be 5% instead of 12%.  People who lent at 12% make a windfall gain of 7%.  Similarly, the borrower loses out to the same extent.

Asset bubbles occur when demand push inflation leads to assets becoming overvalued when compared against their fundamentals.  Say all the trendy kids at school are getting balloons, they’re pink and shiny, and kids without balloons will be a laughing stock without one.  The newest de rigeur balloons are designer ones with trademarked logos and are priced at $19.95 (even though the materials they are made from have a true cost of 3c).  Kids save their pocket money for weeks to get a shiny pink Niko TM balloon with the fancy swish.  Some even borrow money from their parents to get one.  Then one day a popular kids suddenly realises that balloons don’t really DO ANYTHING, and that he really only would be prepared to pay $0.05c for one.  He sets a trend, and suddenly the bottom drops out of the designer balloon market and a bunch of kids are in hock to their parents for $19.95 with only a piece of balloon rubber filled with air that has a market value of $0.05c.  That’s nasty, but deflation often follows the bursting of an asset bubble and is probably the most horrid scenario.  The kids stand around with their $2 of pocket money in their pocket.  On Monday, the Balloon salesman’s advertising board said $1, on tuesday it said $0.90c, and today is says $0.70.  The kids stand around wondering whether they should buy balloons, but figure that if they can buy 2 balloons with their pocket money today, why not wait until tomorrow when his price might be $0.50c and then they can buy 4!  So all the kids sit on their $2 knowing it will buy more tomorrow or the day after, isn’t deflation AWESOME!  They say.

Except by Thursday the Balloon salesman goes insolvent for failing to pay the registration on his balloon wagon.  And little Jimmy’s dad was the compressed air salesman, and just got sacked for not making his normal sales to balloon sellers, so he ain’t getting no pocket money at all next week.

Source: How to explain inflation in simple terms – Quora