In today's markets, when the price of oil seems to be on a ceaseless uphill climb and the value of a dollar seems to be sinking more every day, the spectre of inflation is touted again and again. The truth is, the US economy faces something far worse than inflation. It faces stagflation.
Stagflation is a term that strikes fear into the hearts of economists and businessmen worldwide because it can destroy an economy and it is very hard to fix.
What You Need to Know About Money & Inflation
We tend to think of money as a kind of "fixed" group of objects. There is only so much of it in the world, and it moves from person to person when people buy things. Both of those obvious truths are dangerously inaccurate.
Dollars are how we trade things in this nation. We use them to decide the relative value of things. A Jaguar costs more dollars than a Honda Accord, perhaps because more time and materials went into the Jaguar or perhaps because there are just fewer of them.
Now, if there were only a fixed number of dollars in an economy, we'd have a huge problem. Because we actually make more stuff every year. If we increase the number of objects in an economy and keep the same number of dollars, the "price" of every object in dollars goes down.
For example: If there are only ten dollars and ten apples in the world, you might pay a dollar per apple. But what if there are suddenly twenty apples? The price of an apple might fall to $0.50 (half a dollar). The guy growing apples would think his apples weren't as valuable as they used to be, and he would probably decide to produce less. The same "falling price" rule applies to almost everything. What if you found out tomorrow that your job suddenly paid half what it currently does? Wouldn't you quit and find something else to do?
Now that you understand why we need more money circulating every year, you'll be happy to know that the United States has a way to increase the amount of money to keep up with the production of things. Actually it has several. First, the government can just print money. It uses all kind of complicated tools (like buying bonds or making loans to banks) to release more money into the economy. It often does that when it wants to fund things like wars.
Understanding Deflation
The Federal Reserve actively manages money all the time. It sets the rate at which banks can borrow money from the Fed to loan to others. In the months after 9/11, the Federal Reserve set the reserve rate very, very low to stimulate the economy. They had to do that because businesses and consumers were not spending money and many costs (like airline security) had suddenly skyrocketed. Without the infusion of cash, nobody would have bought anything and businesses would have stopped producing the stuff people weren't buying. Businesses would have laid people off, thus further reducing the ability of people to buy things.
That downward spiral is called "deflation" and many folks blame it for the Great Depression. The stock market crash of 1929 sucked a huge amount of money out of the economy, and failure to put it back in made businesses stop production and fire workers, who subsequently wandered the streets looking for something to do. Some guy called Keynes said we'd fallen into a "liquidity trap" and convinced the government to spend money on stuff like building Hoover Dam. The economy got a little better. We had a big World War, the Government printed a bunch of money, and it got better still. That was the economic boom of the 50's.
By this time you understand that money is not a passive thing. Changing the amount of money circulating in an economy, shocks that dramatically impact spending habits, dramatic increases in the real cost of things (like oil) relative to other objects (like food) can have a massive impact on the lives and well being of people who have to live in that economy.
Which Brings Us Back to Stagflation and the Credit Crunch of 2007
Having read all this, its easy to imagine the Government should just print money all the time. Obviously its good for production. The problem is, the more money you have circulating, the less any given dollar can purchase. If you are fan investor with a lot of cash, a person living on a pension, or a country that has a lot of its wealth in dollars, you don't like having the dollars you hold become worth less every single day. So you use those dollars to buy something like Euro's that hold their value a little longer. If you are selling things to people with dollars, you charge them more dollars every day. The result is no one wants dollars and prices in dollars go up very fast.
Over the last seven years, the price of oil has gone from $30 a barrel to over $100 a barrel, resulting in $1.29 gallon of gas going up to over $3.50. The cost of health insurance has gone up by more than 400%. The average price of a house in some areas has almost doubled. The cost of food has risen more than 10% this year alone. Five years ago the Dow was at 8000, and earlier this year it was at 14000. That increase far outstripped the growth the nation saw in real production during that time.
Very low interest rates implemented by the Federal Reserve after 9/11, and the increased government deficit spending occasioned by the War on Terror, have created much inflation in the price of things. Wages, have not kept pace with with inflation. An employer who gets twice as much for his bread may not instantly decide to pay his bakers twice as much.
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