I NFLATION II : T HE E CONOMY S TRIKES B ACK Mr. Marinello * Chippewa Valley

C AUSES OF I NFLATION - T WO D IFFERENT K INDS Demand-Pull Inflation: Results when total demand is rising faster than the production of goods/services. Total demand rises faster than production, this creates a scarcity that then drives up prices. It takes time for producers to recognize a rise in demand and prepare for higher production. Until producers can match consumer demand, there is a scarcity and price will increase.

The US government creates and controls money through the Federal Reserve Bank. If the government creates too much money during the lag period before the increase in production can match consumer demand, there will be too much money chasing too few goods, and prices will rise. The creation of excess money is the main reason for demand-pull inflation.

Cost-Push Inflation: Prices are pushed upward by rising production costs. When production costs increase, this creates less of a profit. If consumer demand is strong, producers may raise their prices in order to maintain their profits. Supply shocks: Sharp increases in prices of raw materials or energy & 1974 members of OPEC limited the amount of oil they sold to the US, which caused prices to increase. This rapid rise in the price of oil led to cost-push inflation. Wage-Price Spiral: Workers receive a wage increase  the wage increase drives up the production costs  higher prices  workers demand a wage increase to pay for higher prices.

T HE I MPACT OF I NFLATION Effect 1: Decreasing Value of the Dollar With inflation, today’s dollar buys less than last year’s. Inflation decreases your purchasing power. Milk per glass $.50. With $1, you can buy two glasses of milk. With inflation, milk now costs $1 per glass. You can only buy one glass. Your purchasing power just went down. People that have fixed incomes, incomes that do not rise each year, are especially vulnerable to the decreasing value of the dollar through inflation.

Inflation can help borrowers. Those who borrow at a fixed rate of interest can repay their debts with dollars that are worth less, making their repayments smaller then they would have been without inflation. You want to buy a new house. You take out a 30 year fixed mortgage at 5%. You will have the same mortgage payment each month no matter what. Same price in 2010 and in 2025.

Effect 2: Increasing Interest Rates As prices increase, interest rates also tend to increase. Lenders raise their interest rates to ensure they earn money on their loans despite inflation. Higher interest rates mean that borrowing money becomes more expensive. When interest rates are high, businesses are less likely to borrow to expand. When rates are higher, consumers are less likely to make purchases of high-priced items that they would need to finance.

Effect 3: Decreasing Real Returns on Savings Inflation can have a significant effect on savings. People who save at a low fixed interest rate will get you a lower return on their savings because of inflation. Put $100 in a savings account that pays 5% interest they will have $105 at end of the year. But if the rate of inflation for the year was 10%, that $105 will be worth less. Although they will have more dollars, that money will buy less. Inflation can discourage savings.