Inflation and liquidity

Inflation is the name given to a general increase in prices. It can mean a general increase in prices across all goods, a general increase in prices in a particular industry, or sometimes even an increase in prices of a particular good.

There are a lot of different causes of inflation. Inflation can occur because there is a lack of supply in some relevant industry - for example, if there is less oil available, then transporting goods will be more difficult and end up costing more, and since the price of the goods on shelves includes the cost of transporting them there, the price will go up. Inflation can also occur because more people want a particular good or set of goods, and the competition for those goods means that sellers can increase the price. Inflation can also occur because people expect the price of something to rise. They might think that a constraint in supply is about to occur and raise their prices in anticipation. Inflation can also occur when lots of new money enters the economy. In this case, more people have more money to spend and therefore increase their demand on goods, which causes the price to rise.

Liquidity is the ease with which exchanges can be made. People are very happy to transfer money to each other, both because they know that they will be able to trade it on for things that they want, and also because it is easy to transfer to another person. A house, on the other hand, while it can have a very high exchange-value, can't be as easily transferred. People have to take their things out of the house, find a new place to live, figure out the value of the exchange, and find someone who wants that particular house, given that all houses are different. (Money has an easier time here because each dollar is the same.) Money is therefore more liquid than houses. An economy needs enough liquidity - that is, enough ability to transfer money - for economic activity to occur.

The role of central banks

Central banks are banks that are run by governments to implement "monetary policy", which is usually an ambition to control inflation and unemployment. Central banks also require commercial banks - the ones that the public and businesses usually interact with - to deposit some funds overnight, and charge them to do so. This charge is the "cash rate" or interest rate. Central banks also ensure that there is liquidity for commercial bank loans - that is, that if a commercial bank loans out money, the person obtaining the loan can access the money.

In addition, central banks can do things like buy up financial assets such as bonds. When the central bank buys bonds they exchange them for money. Because money is more liquid than bonds, the liquidity of the economy increases when this occurs. This is called "quantitative easing". The reverse can also happen, where the central bank sells bonds and ther financial assets, depositing the bonds at a bank and receiving money, which is effectively taken out of circulation from the economy. This is called "quantitative tightening".

So central banks have a job: don't let inflation get out of hand. And many also have a second job: don't let unemployment get too high. Central banks have a few things they can do to try and control these things: they can raise and lower the interest rate, making it more or less expensive for commercial banks to loan money; and they can buy and sell bonds and other financial assets to increase or reduce liquidity.

The inflation target

A lot of central banks have an inflation target between 2% and 3%. That means that they are aiming for prices to rise a little bit every year, but not too much. If they think that prices aren't rising quickly enough or that the economy is not very liquid, they can lower the interest rate, which means that commercial banks are likely to loan out more money, and people are likely to have more money and spend more, which can push up prices. They can also buy financial assets, which will put more liquid money into the economy and have the same effect. If they think that the economy is too liquid or that prices are rising too quickly, they can do the reverse.

If prices rise too quickly, it can lead to an "inflationary spiral". People will be unable to afford things, and ask for more money from their employers, but higher wages will mean that businesses might believe people can spend more money and will increase prices again. On the other hand, if wages don't rise, people will have trouble buying all the things they need, and will forego other expenses, leading to businesses not making enough income to pay all their workers.

The opposite is a "deflationary spiral", where people aren't willing to pay high prices, and so businesses have to lower prices and make less income, often resulting in laying off workers, who are then constrained in their spending and reduce general demand, leading to lower prices and more business collapses.

If wages rise, people who are holding debt now have more money to pay it off, while if they fall they have less money to pay it off and are more likely to default.

Thus, if inflation is too high or too low, the economic has a problem. Economists generally identify a "sweet spot" between 2% and 3%. One reason why the target is not 0% is that just a little change will cause deflation, which is generally regarded as a worse problem than a little bit of inflation.

Another reason is that, in a system of exchange, people are motivated to store goods for their exchange-value (including money). But if goods are stored rather than exchanged, and if money is saved rather than spend, then economic activity can slow down. This is one of the reasons why deflation is seen as so dangerous: if $100 can buy a lot of goods now, but it could buy more good later, then there is a motivation to save it up instead of spending it.

An inflation target of 2%-3% means that $100 today will buy a little bit less in the near future, and so people are encouraged to spend it today, keeping economic activity going.