TL;DR Science: Currency Inflation

By Thomas P.
October 27, 2021 · 4 minute read

Mathematics

Statistics

Currency inflation is a measure of the value of the U.S dollar and other currencies. Over time, inherently paper currency tends to depreciate in value; this can be measured by the Consumer Price Index. For example, have you ever wondered why a soda cost a quarter in the 80’s but now $1 more in the 2020’s? Now before you are able to understand currency inflation and why it happens, we need to understand supply and demand.

The principle of supply and demand

If the number of buyers who demand an item exceeds the supply of it, the price will increase. If the supply of the item exceeds the amount of buyers, the price of the item will decrease.

There are three types of inflation:

The demand-pull effect

The demand-pull effect is easy to understand because it is merely caused by an increase in the total amount of currency there is in the economy. The demand-pull effect can also be caused by an increase in “credit”, meaning that banks are more willing to lend money at lower interest rates.

Here are two scenarios:

Scenario 1:

Congress decides to give everyone a huge tax break. As a result, people have more money to spend as well as cash on hand. This results in higher demand for all items across the economy, causing prices in every sector to rise. Thus, the value of $1 is worth less, given one cannot buy as much with that $1. In the end, the tax break does not give consumers as much money to spend with.

Scenario 2:

The Federal Reserve (the principal paper money regulating agency) lowers bank interest rates, and thus is able to lend more money to consumers’ banks. Then, consumers’ bank loan interest rates also fall. As a result, more people are eager to borrow money from banks, and thus, the populace has more money to spend, but is not necessarily richer because of inflation.

It is easier to understand the other two types of inflation after learning about the demand-pull effect!

The cost-push effect

The cost-push effect has the same outcome as the demand-pull effect, but the opposite cause. In this case, the immediate cause is a smaller supply of items in all sectors of the economy as a result of a shortage of raw materials - such as oil. This causes the prices of items in every sector of the economy to increase, thus making the currency less valuable.

Built-in inflation

The last type of inflation is an odd phenomenon given it is the result of a feedback loop. Because workers know that the Federal Reserve is going to keep inflation around 2% yearly, they will often demand that their employers give them a raise of that amount. The result is that the employer must charge more for the goods and services that they sell; when this happens across industries, we see inflation. Built-in inflation only happens because people intentionally cause it.

Why might inflation be bad?

Inflation reduces the value of money over time. This can pose a problem for people who do not store their money in banks, but rather under their mattress. For example, say one hundred years ago a man who knew nothing of inflation hid $30,000 hoping that someday his grandchildren would be able to use it to buy a mansion. Unfortunately for him, his grandchildren would only now be able to use that money to buy a commuter car - maybe the base model of a cheap Mustang if they’re lucky. Yet, saving money is an admirable trait; which is why inflation can be bad. In addition, the inflation of the U.S. dollar can weaken the currency, meaning that other currencies may have more buying power than the U.S. dollar.

Why might inflation be good?

Now inflation is not entirely evil - there is a good side to it. It fortunately can help economies grow, as it forces people to spend money.

There is also a theory that contests that a small percentage of inflation can help economies grow if the consumer rush to spend as a result of inflation happens just before prices go up. This is why the Federal Reserve often tries to keep the percent of inflation around 2% yearly.

Youtube video: https://www.youtube.com/watch?v=UMAELCrJxt0

Related article regarding economics’ connection with STEM: https://sciteens.org/article/tldr-majors-economics as both a branch of social sciences and applied mathematics.