Inflation: Cause & Effects

In the 1940s, an ice cream cone cost a couple of cents. Today, it will cost several dollars. This increase in the overall level of prices is a result not of a shortage of ice cream, but because of inflation. Overall prices in the economy have risen on average about four percent per year over the past 70 years. As a result, each dollar in our wallet now buys a much smaller quantity of goods and services than it had in the past. In other words, over time, our money has become worth less.

The rate of inflation varies substantially over time. In 1980, the average rate of inflation was 13.58 percent. Three years later, the average rate of inflation was 3.22 percent. Nowadays, the average rate of inflation is roughly 2 percent, though since the economic downturn in 2008 it's been decreasing steadily. At the current rate, prices will only double every 33 years.

In general, when economists talk of inflation they are referring to the growth of the supply of money (the currency). Excluding credit expansion, the money supply grows in the United States when the Treasury Department issues a bond (a debt instrument) which is then purchased by the Federal Reserve with dollars. The Treasury Department then uses those new dollars, secured through debt (the bond), to pay for present spending that the President and Congress agreed upon.

Normally, the government raises revenue by levying taxes. The scenario above takes place when the government doesn't have enough money to pay for its spending or lacks the political will to raise taxes or both. When that happens, the government is said to levy an inflation tax.

Inflationists argue that a little inflation is a good policy that grows the economy and helps bring stability through low unemployment.

Others would argue inflation discourages saving, encourages speculation in assets (think stocks or houses), and distributes wealth to early-receivers while making late-receivers poorer.

Those opposed to inflationary policies admit that inflation will increase production and economic growth, but that that growth is a false growth enabled by cheap money. They argue that when the government takes on debt to inject money into the economy, the value of money decreases and price levels rise. After an injection, the early-receivers of the inflated money have more money to spend; the demand for goods and services increases as a result. Those last to receive the monetary injection find they have less purchasing power. As prices rise, the quantity of money demanded for goods and services increases. The process continues until a government can no longer take on debt. When the government is no longer able to borrow in order to inject money into the economy, a deflationary correction takes place, or worse, monetary collapse.

Debate currently rages over whether or not the United States faces a future of deflation or inflation. Learn about inflation in this section. To learn about deflation, click here.