A small town out in the middle of nowhere had a thousand residents. Five hundred of its residents worked for the town's main employer, a small oil-drilling company. One day, the company hit a major pocket of oil and everyone was rich!
When the only two cows for sale in town were brought to the monthly auction by farmer Jed, the bidding started at the normal $100 for the pair. But, instead of rising slowly like the price usually did, it quickly soared to $600 for the pair! Farmer Jed's cows once went for $300 but never before had he reached so high a price. The reason for this is that the residents had a lot of money now, but there were still only two cows for sale in the entire town. Now, $300 would get you only one cow - if you were lucky.
This story illustrates the principle of inflation - the decrease in the buying power of one's dollar. There are several possible reasons behind why that piece of candy you bought when you were a kid is now four times as much, but your salary isn't four times higher than what your parents made at that time. One of these, the one most commonly associated with the term "inflation," occurs when the amount of currency in an economy increases but the inventory of available goods doesn't. Subsequently, this increase in the ratio of money to goods raises the price of each item.
Another potential cause of inflation is an increase in the cost of doing business. If it costs me $2 to bake a loaf of bread and I sell it to you for $4, a wage of $12/hour enables you to buy three loaves of bread. All of a sudden, the price of flour skyrockets and it now costs me $4 to bake a loaf of bread. Since I must make $2 per loaf to pay my personal bills, I must increase the price to $6 a loaf. Now, your hourly wage only buys you two loaves of bread.
A third aspect that drives inflation is the availability of a good or service. Not only does it inherently cost more to provide less of something due to fixed costs, but people are willing to pay more for a rare item if they really want or need it. If there are ten sandwiches available and there are five hungry employees, the price per sandwich will be less than if there are ten hungry employees and five sandwiches. The increase in scarcity of an object decreases the buying power of your dollar when you go to purchase it.
Ultimately, a small amount of inflation is to be expected in a healthy economy. Inflation doesn't become problematic, however, unless it grows very quickly or if it increases at a high and steady rate. If inflation begins to sharply rise, the "snowball effect" can come into play. In an attempt to avoid future price increases on goods, people often try to stock up; typically buying more items than usual. If all goods in a society are increasing in price and everyone attempts to stockpile, the available supply of goods drops. The drop in supply drives higher prices and this further spurs people into stocking up before it's too late. Inflation can grow exponentially at this point, if this cycle is left unchecked.
However, governments monitor the rate of inflation in a number of ways. By examining the rate of inflation and its underlying causes, they're able to take steps to reduce its effect on society and, hopefully, before inflation gets out of hand. By changing tax policies, modifying interest rates on government loans, selling government bonds or other securities, or by starting or ending military conflicts, governments can raise or lower the amount of money in use and, thereby, the rate of inflation.
