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Feb 13, 2018

Why Is Inflation Important for the Economy?

By Lindsay Goldwert

Inflation plays a very important role in the economy, and it can affect your income and savings.

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You’ve probably heard of inflation before, but if you’re like most people, you aren’t entirely sure what – if any – role it plays in the economy.

The truth is that it actually plays a very important role, and it can affect your income and savings.

Why Inflation Is Important to the Economy

Inflation essentially works as a stabilizing tool for the economy. Without a central bank being able to control the highs and lows of an economy, it would almost certainly end up spiraling out of control and crashes like the Great Depression would be inevitable.

Why Do Prices Go Up and Down to Begin With?

Why do prices go up and down, though?

There are countless reasons, but here are the main two:

  • Supply and Demand: Change to the supply and demand of any goods is going to affect prices. For example, if the supply of certain goods goes down, prices will go up because companies can charge more for the smaller supply. On the other hand, if demand drops, companies will have to accept less for products that fewer people now want.
  • Consumer Confidence: Consumer feelings about the economy can affect demand, but it’s worth considering as a broader phenomenon. Consumer confidence refers to how optimistic consumers are about the economy. If they’re feeling good about it, they’re likelier to spend more, because they aren’t worried about losing their income sources anytime soon. If they are concerned about losing their jobs, they’re going to spend less, based on fears that they may need their savings sometime in the near future.

There are a number of other reasons for prices to go up or down. Wars and natural disasters are two examples that can also cause inflation to rise.

How Central Banks Affect Inflation

Central banks like the Federal Reserve are tasked with deciding a country’s monetary policy. One of their prime tasks is ensuring a healthy rate of inflation. Central banks do this by adjusting the money supply. The more money is available, the less each dollar (or other unit of currency) is worth. The more they reduce the supply, the more each unit is worth.

This is basic supply and demand.

If the rate of inflation gets too high, a currency can become virtually worthless. Countries with high inflation rates are generally impoverished. One of the best examples of this was the German hyperinflation of 1923, where things became so bad  that people used wheelbarrows for wallets.

The more money is available, the less each dollar (or other unit of currency) is worth.

At the same time, too much deflation–the opposite of inflation, when prices drop for an extended period of time– is bad, too. During the Great Depression, deflation played a central role in preventing the economy from recovering. As prices continued to fall, companies struggled to turn profits, which they needed to employ people. Falling levels of employment made it impossible for the economy to stabilize.

A more recent example of a central bank stepping in to introduce stability to an economy was the Federal Reserve using quantitative easing, following the financial crisis that began in 2008.

In the years immediately following the recession, consumer confidence was low, but inflation remained at moderate levels. Quantitative Easing provided the economy with a fresh supply of money, which encouraged people to start spending, helping to bring the economy back to life.

What Inflation Means for You

While inflation can be beneficial for the economy, as a whole, it’s almost never a good thing for the individual. It means your money is worth less.

Fortunately, the Federal Reserve using inflation to stabilize the economy doesn’t have to hurt your savings.

By signing up to Stash, you can easily begin investing your money with as little as $5. When you invest you are effectively exchanging cash savings for ownership of assets like stocks or even real estate, investments that tend not to be be affected by inflation as much as cash in a savings account. Stash Learn is also giving new investors a special $5 sign-up credit to get started by just subscribing here.

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Written by

Lindsay Goldwert

Lindsay Goldwert is an author and freelance personal finance writer, as well as the host of Spent podcast


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