Over the past year, inflation in the United States has significantly increased. What is it, why does it matter, and what can governments do to address it? Those are just a few of the questions Ananth Veluvali explores in this briefing.
What is Inflation and Why Does it Matter?
Have you ever wondered why that same bag of chips which used to cost you one dollar now costs you two?
The answer has to do with inflation, which is how much prices for a group of goods and services increase over time.
While there are multiple ways to measure inflation, the Federal Reserve (which functions like a Central Bank of the United States) uses the PCE index, which analyzes the prices of various goods and services in sectors like housing, transportation, recreation, and food & beverages over time (see the image below for a specific breakdown). The Federal Reserve’s target for inflation is 2% annually, which means that, on average, they hope that the prices for the goods and services measured by the PCE will only rise by 2% each year.
Unfortunately for the Federal Reserve, the annual rate of inflation between October of 2020 and October of 2021 was a whopping 6.1%! As an article by the Associated Press noted:
“Bacon prices are up 20% over the past year, egg prices nearly 12%. Gasoline has surged 50%. Buying a washing machine or a dryer will set you back 15% more than it would have a year ago. Used cars? 26% more.”
This high inflation can pose a problem. If prices rise too fast, they can increase quicker than wages can. This means that Americans might spend more and more of their incomes purchasing the same goods.
Who or What is Behind Inflation?
For one thing, consumer demand for certain goods and services is rising faster than the supply of those goods and services. In the early stages of the pandemic, companies prepared for more misery. They cut investment, shut down factories, and desperately tried to sell their inventory. However, the economy rebounded faster than business analysts originally thought, and with it, consumer demand has greatly increased.
The problem? Supply hasn’t been able to keep up with that demand! Indeed, from computer chip shortages to supply chain slowdowns, businesses simply aren’t able to meet consumers’ demand and are playing a prolonged game of catch-up.
While it’s more controversial, many people have suggested government spending has also created harmful inflation. As the government grappled with the economic ramifications of the pandemic, it spent trillions of dollars on infrastructure projects, stimulus checks, and other expensive government programs. In fact, 22% of all US dollars were created in 2020. This could have propped up business and consumer demand, increasing inflation in the process.
The government’s role in increasing inflation could extend beyond spending programs too. In the midst of the pandemic, The Federal Reserve cut interest rates to zero percent, which made it significantly easier to borrow money and/or pay back existing loans. This once again significantly increased spending in the economy, and could have contributed to inflation. For a better understanding of interest rates, you may want to check out our article on the subject here!
There’s no singular factor that brought inflation to where it is today. From political complications in OPEC to a resurgent job market, you may want to also explore the various other economic factors that also could’ve increased inflation.
What Can Governments Do Now?
This is a tricky question to answer. If there were any easy solutions, they would’ve been done by now. Among other things, though, governments can look to the following:
- Working with OPEC+ to figure out how to reduce oil and gas prices.
- Cutting back government spending in a responsible manner. Governments must balance helping people recover from the pandemic with combating inflation.
- Exploring the possibility of raising interest rates. If the Federal Reserve makes it harder to borrow money, people will be more inclined to save their earnings and not spend them.
- Governments can also mull over price controls. This would likely create more problems than solutions, but it’s worth exploring.
- Helping fix supply chain issues. Companies must be empowered by Congress, so they can produce goods and provide services as necessary in order to match consumer demand.
These are a few of the solutions experts have proposed to help the United States tackle its growing inflation challenge. As an extemper, take these solutions with a grain of salt. There are also likely problems you must explore with each ‘solution,’ and there are other solutions out there that were not covered in this article. Really spend some time digging deep into this subject if you want to have sophisticated solutions.
Practice Questions:
Does rising inflation threaten to upend America’s economic recovery?
What steps can the Federal Reserve take to reduce inflation in the United States?
Should the Federal Reserve continue to view current inflation levels in the United States as transitory?
What role has Congress’ spending played in worsening inflation in the United States?
How can Congress help businesses ameliorate supply chain issues?
