Inflation is the term used when the demand for general goods exceeds their supply or the cost to produce them becomes prohibitive. This simultaneously causes prices for the things we buy to become higher and the purchasing power of the country's currency to become lower. Therefore, it costs more to buy the things we need and inflation results in the loss of value in money.
The Fed employs various methods to control inflation, attempting to maintain a rate between 2-3% per annum. An example is a candy bar that cost $1.00 this year would rise to $1.02 the following year, based on a 2% rise in inflation. Some theorize that inflation is also directly connected to the money supply of the economy as well.
Meaning, if a large amount of “money” is funneled into the economy it causes a sharp rise in the cost of goods. And history has shown that if, as money supplies rapidly increased, prices spiked and the value of money fell drastically, thus contributing to economic collapse.
today's economy. Being that most world currencies are fiat money, the money supply could increase expeditiously for political reasons, causing rapid inflation. A marked example of this is the hyperinflation that struck the German Weimar Republic in the early 1920's. War reparation was demanded and Germany sought to pay their debts with foreign currency they had purchased with hastily printed notes. This deed failed miserably and led to the rapid devaluation of the German Mark. German citizens exacerbated the situation by frantically spending the new money in circulation, causing more money to flood the economy and accelerated the plummet to the point where money was used to paper household walls! Inflation is generally measured through the consumer price index, or CPI, which tracks the cost of a core group of products and services.
While excessive inflation and hyperinflation have negative economic consequences, deflation's effect on the economy can be worse. This occurs when the inflation rate falls below 0%, allowing more goods to be purchased with less money. Although this sounds like an ideal situation to the general consumer, if declining prices persist, they often lead to a vicious downward spiral. Negative conditions such as, falling profits, closing factories, unemployment, shrinking incomes, increases in loan defaults and economic depression are then realized.
Deflation occurs due to such economic climates as a reduction in the supply of money or credit or a decrease in government, personal or investment spending. Japan's “lost decade(s)” is a relevant example of the lasting negative effects of deflation. They have been attempting an economic rebound for almost 20 years. Perhaps the most unfavorable economic state for a country to be in would be stagnation. This is a marrying of inflation and stagnation. When economic growth is sluggish, prices of goods and services rise and unemployment rates are elevated. This occurred on an international level in the 70's, when world oil prices rose dramatically, fueling colossal inflation in developed countries.
The rise and fall of inflation are the primary reason why consumers decide that investing the bulk of their money is the most prudent course of action. Just as the candy bar would rise to $1.02, a savings account of $1,000 would fall to 903.92 after 5 years, assuming no interest is earned on the deposit. That is why, buying a tangible asset like gold, makes the most sense for people living in an unstable economy.