Inflation

Inflation is an extremely important economic variable to understand. Inflation is the rate of change in the average price of goods and services in the economy.

12-month inflation rate from US Bureau of Labor Statistics

Inflation can be caused by a variety of factors, such as printing too much money or price gouging. But inflation is primarily driven by supply and demand. When demand for goods and services, or consumption, is greater than can be accomodated by production, the price of those goods and services will increase.

The Consumer Price Index or CPI is the way we keep track of how much things cost. It is calculated by selecting a basket of goods and services that people use on a regular basis and recording its price over time. The basket includes things like shelter, food, energy, health care, education, and transportation. You can read more about what is included in the CPI here.

Effect of Inflation

Inflation reduces the purchasing power of your money and makes it more expensive to live. When the CPI increases, the $100 in your savings account can no longer buy as much stuff as it could before, meaning that $100 is no longer worth as much. This is why inflation is said to erode the value of money over time.

This seems pretty scary, right? But inflation in small amounts is seen as positive and even necessary for the economy. This is because the fact that your money will be worth less in one year's time encourages people to spend money now instead of later - if the price of a new car will increase next year, it is better to buy it now. This supports the economy by increasing the flow of money, increasing revenue, and creating jobs.

The US Federal Reserve's target inflation rate is around 2%.

When inflation becomes too high or too low for sustained periods of time it can be detrimental to the economy.

When prices rise significantly, consumers cut back on spending which effects the profit of businesses and could the economy to enter a contraction. Discretionary or non-essential items are the first to be cut, so businesses that sell these are the most effected.

Deflation, when prices actually decrease over time, can also cause the economy to enter a contraction. Deflation occurs when the demand for goods is less than that supplied by businesses. While this may seem like a good thing at first, consumers are incentivised to save and begin to delay their purchases since they anticipate cheaper prices in the future. This causes the flow of money to slow, revenue to decline, and wages to fall.

Inflation also increases operating costs for businesses. This is where pricing power becomes important. Businesses are able to increase the price of their goods or services without suffering a significant drop in sales will fare better than those which can't. Pricing power can come from selling an essential product (think supermarkets, utilities, housing), high switching costs, limited competition, or brand loyalty.

Unemployment

Unemployment is another important economic factor to consider. Unemployment occurs when someone is actively looking for a job but is unable to find one.

Employment is an essential factor in both productivity and consumption within the economy. Businesses require labour to produce their goods and services. Employees then spend their salary on other goods and services which boosts consumer spending and stimulates the economy.

To understand unemployment, there are a few definitions to keep in mind. Firstly, the unemployment rate is the percentage of people in the labour force who are unemployed.

The labour force includes all people who are either employed or looking for work. People who are not looking for work, retired, or permanently injured or disabled are not included.

The participation rate is the percentage of the total population who are in the labour force. When the participation rate rises, the size of the labour force increases and unemployment rises, and vice versa.

This participation rate is important to understand because things that effect the size of the labour force will impact the unemployment rate even if the number of employed people is unchanged. For example, during Covid, many people left the labour force by choosing to retire early or stay home to care for children or family. When these people decided to start looking for work again, the unemployment rate spiked even though the total number of employed people was the same.

Other than the participation rate, the unemployment rate is a function of the number of jobs available. When profits are high, businesses increase hiring which decreases unemployment. On the other hand, when profits are low businesses reduce hiring or even layoff existing employees in order to cut costs.

During contractions businesses have to cut costs, and one of the largest costs is labour. The unemployment rate rises, and as a result people have less disposable income for consumption causing demand to fall further.

A little unemployment is not actually a bad thing and occurs naturally as people switch between jobs (called frictional unemployment). Some unemployment is a good thing as it gives businesses a wider range of candidates to choose from to ensure they match with the most qualified. Central banks tend to target a moderate level unemployment, called the natural rate of unemployment, to prevent inflation.