What exactly is inflation?

[SavingMentor]

I have a general idea of what inflation is and how it works, but there are still a few details that puzzle me. I read this article, but I still have some questions.
Ultimately, I’d like to understand how it affects my personal finances. Talk to me like I’m a kid. The simpler the better!

[brunt]

I have a general idea of what inflation is and how it works, but there are still a few details that puzzle me. I read this article, but I still have some questions.
Ultimately, I’d like to understand how it affects my personal finances. Talk to me like I’m a kid. The simpler the better!

There are two ways to answer this.

1) The first answer is from an academic standpoint. The formal way of stating this idea is that inflation is a monetary construct. What exactly does this mean? Well an example will help.

Imagine a closed economy on a desert island. Nothing comes on or off of the island. People living on the island will work, making food, shelter and clothing, and they use wooden beads as money to make the transactions a little easier. There is pretty well a fixed supply of wooden beads, and after a while, prices for goods and services (in terms of wooden beads) will settle to a value that reflects quality, supply and demand of each good. Sure, prices may fluctuate a little as a particular type of fish or vegetable becomes more or less available, but prices are pretty stable.

Now, imagine if all of a sudden the person in charge of making wooden beads went crazy making beads, all of which were distributed evenly amongst the residents of the island. The initial reaction, of course, will be each of these residents thinking "gee, I am far richer today than I was yesterday".

But imagine what happens in the island stores. Each of these stores has as many items in them as they normally do, since there has not been any change in the number of workers on the island, nor has there been any change in technology. What has changed is that the customers coming into these stores now has far more beads than they used to have.

What does the person running the store do? If they keep the prices the same as they were before, they will totally sell out of stock in no time, and be left with angry customers with beads with which they are willing to buy items, but no items on the shelf. So they increase their prices accordingly, making sure that all their customers will be satisfied.

Some customers will grumble at this "greedy" shopkeeper for increasing his prices, but the shopkeeper did the right and fair thing to make certain that the maximum number of customers can be served.

Just image what you would do if whatever you do for a living had a situation where multiple employers were tripping over themselves offering you money for your services. You will notice this, and increase the wage at which you will do the work. You cannot possibly work for them all, so you have to find a price where they are willing to pay and you are willing to work.

This is the "true" definition of inflation - an increase in the money supply. On our island, the number of wooden beads increased. With our governments, the number of dollars increased.

2) The less correct definition of inflation is simply the increasing of prices.

When 99% of the people mention "inflation", they just mean that prices are increasing. This is not really informative, because why are they increasing? Is there a shortage of supply - was there no rain and the crops failed? Was there a disease amongst animals that we use for food? Was a road washed out so that no food can get to the stores?

All of these can cause prices to go up, but they are not really "inflation".

No, the first definition of inflation (the increase in the supply of money) has the result of increasing prices. Technically, the increase in prices is not inflation, but rather is the result of inflation.

To put this all in context, the federal government has thrown an insane amount of money at Covid. Like, far more than we spent in WWII insane amounts of money. They whipped up new money by sending cheques out to businesses and individuals all over the country to a degree that is mind boggling.

We can argue all day as to whether or not this was a good idea, or what amount of money would have been a good idea, but it all boils down to an immutable economic law:

If the supply of money increases without an increase in the number or quality of goods and services produced, then prices will increase.

This is, in a nutshell, what inflation is all about. And when you understand how simple it is, you have to shake your head at why it is that every government that has ever existed has always responded with shock to the fact that prices increase when they increase the supply of money.

[Shwa Girl]

Thanks @brunt !

[walkonby]

@brunt !! Thank you so much for clarifying in detail the real definition of inflation. I was part of the 99% who figured inflation was simply prices increasing and usually I'd point to whatever crops that had failed or another " cause " thinking that alone was the why of the increase.
Excellent post!

[Purdee]

governments print more monies also decreases the value of their monies; $1 canadian dollar can worth 20,000 or more of some countries' monies and of course the other way around if you compare canadian dollar to usa.