Inflation can hurt people’s wallets, especially when prices rise too high, too fast. Given the financial strain, you may wonder why prices keep rising and don't stay at the same level.
While zero or negative inflation may sound ideal, there are reasons why this scenario isn’t a common one. Read on below.
Governments set inflation targets
Governments generally want to maintain a steady level of inflation. Central banks – institutions that manage a country's money supply – typically target a 2% annual inflation rate as it is considered the “sweet spot” for price stability.
Here’s why:
- To maintain a healthy economy
A little inflation is widely considered a good thing. Manageable inflation often signals that an economy is growing at a sustainable pace.
When people expect goods to become more expensive, they are motivated to spend and invest sooner instead of delaying their purchases.
Consumer spending helps businesses grow and allows them to create more jobs, which fuels further economic growth.
To sustain this virtuous cycle, central banks use tools like interest rates to help nudge inflation toward the target.
If policymakers want to provide a boost, they may cut interest rates to make borrowing more affordable for individuals and businesses.
Conversely, when inflation is too high, central banks can increase rates to slow borrowing and help cool economic activity.
- To avoid a deflationary spiral
Inflation targets are also meant to prevent deflation, which is when inflation turns negative and prices drop.
While lower prices sound appealing, deflation can trigger a downward cycle that hurts the economy, businesses, and even consumers.
If people think goods will be cheaper next month, they may hold off on making big purchases. When consumers hoard cash, businesses lose revenue and may need to cut staff.
If workers lose jobs, they tighten spending even more, driving prices even lower. This is why central banks aim to keep inflation from turning negative.
Prices are affected by supply and demand
Though central banks work to keep prices stable, events outside their control can push prices up.
The basic force driving prices is supply and demand. Prices tend to stay low when supply exceeds demand. When goods are scarce and/or are in high demand, prices rise.
Think about local and global examples of major supply disruptions. When natural disasters destroy crops and infrastructure, food prices typically go up.
Conflict between countries can cut off supply chains, increasing costs for fuel, transportation, and manufacturing.
Central banks can’t fully control these forces but can respond through monetary policy.
To combat inflation personally, you can adjust your budget, invest to possibly grow money faster than inflation, and find ways to boost your income.
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