Inflation
All the government will achieve by printing double the number of pieces of paper is to double the price level; you end up with a huge round of inflation. Inflation is nothing more than a continual rise in the level of prices caused from "too much money chasing too few goods."
In the above example, nobody is better or worse off in terms of purchasing power. You have twice the money and everything costs twice as much. The damage that inflation does, though, is creating a fear factor in terms of future purchasing power.
For example, we said earlier that the interest rate is the price that balances lenders and borrowers. If you are willing to loan someone $100, you may be willing to do so if you receive $110 in one year. If so, your return is $110/$100 = 1.10 or 10%. However, let's say that prices rise by 3% during that year. If so, your return is reduced from 10% to $110/$103 = 1.067 or 6.7%. The $110 you receive in one year can then be used to purchase goods that cost $103, meaning you are only better off by 6.7%. The inflation has reduced your purchasing power from being better off by 10% to only being better off by 6.7%.
Economists like to break interest rates down into two components called the nominal interest and real interest rate. The nominal interest rate is just the stated rate. If you buy a 10% bond, the nominal interest rate is 10%. However if inflation is 3% over the time you own the bond, your effective purchasing power is increased by only about 7%, which is the real interest rate. It is the real interest rate that is of concern to investors.
As an investor, it should make no difference to you if you earn 10% with 0% inflation (real rate of 10%) or 13% with 3% inflation (real rate of 10%). Although not technically exact, a basic formula for calculating the real interest rate is:
Using our previous example, we can see that a 10% loan paid back during 3% inflation actually yields 10% - 3% = 7%, which is very close to the actual answer of 6.7% we calculated earlier.
It is this loss of purchasing power that is the real threat of inflation. If you want 10% more purchasing power in one year in exchange for making a loan today, how much should you charge if prices are continually rising? Obviously, that's difficult to answer if you have no idea by how much prices will rise over the year. Because of this uncertainty, few people want to loan money and the entire financial system weakens. Further, under inflationary environments, buyers want to buy today before their purchasing power is eliminated while sellers delay selling in hopes of higher prices tomorrow. This creates more buyers than sellers and intensifies the rising prices.
One of the Fed's goals we mentioned earlier is to maintain the stability of the financial system, which you should now understand means controlling inflation levels. How does the Fed control that? They simply control the supply of money. Inflation is a monetary phenomenon. If the money supply grows by 3%, then prices will rise by 3%. While inflation is a concern of the Fed, there is an opposite effect called deflation that can be more devastating to an economy.
Deflation
Deflation is just the opposite of inflation and is defined as a continual decrease in price levels. Many people mistakenly think that if inflation is bad, then deflation must be good. How can falling prices be bad? What makes deflation dangerous is the cause of the falling prices. In a healthy economy, falling prices are due to competition and increase the levels of demand (remember, lower prices mean that people will buy more). However, in deflationary periods, the prices fall due to contractions in demand – people are simply not spending. The unexpected price declines hurt borrowers and therefore threaten the solvency of banks, which are then forced to restrict credit. This restriction in credit makes it even tougher for people to spend money but that's only part of the real threat of deflation.
Normally the Fed can influence this lack of spending during a recession by lowering interest rates. However, it's much tougher to do, if not impossible, during times of deflation. That's because the Fed can only control the nominal interest rates. Just because the Fed announces a rate cut doesn't mean that investors will react to it and spend. That will depend on investors' expectations of inflation.
For example, if a recession hits without deflation and the Fed lowers rates far enough, it is possible for the real interest rate to fall below zero. For instance, if nominal interest rates are 2% and inflation is expected to be 3%, the real interest rate is negative 1%. A negative return on your money means that you are better off spending money than holding it, which is exactly what the Fed wants you to do. In other words, spend your money today before it is worth less tomorrow. Notice that this negative return on money is possible under an inflationary environment.
However, if deflation is present, real interest rates can never become negative. For example, if a recession strikes and deflation is present with prices falling by 3% per year, the very best the Fed can do is make nominal rates zero. Remembering that deflation if simply negative inflation, the real interest rate is:
0% nominal rate - ( - 3% inflation) = 3% real interest rate.
Notice that the 3% real rate is the same as the rate of deflation in the example. In fact, with a 0% nominal rate, the very best the Fed ever can do is making the real rate as low as the rate of deflation. If deflation were 5%, the real interest rate would be 5%. The danger from deflation is that the faster prices fall, the higher the real rate becomes! The higher the real rates, the less people spend, which leads to further recession and greater deflation and on and on – the economic death spiral has begun.
The Fed therefore has the daunting task of creating the proper amount of money in the economy. If there is too much, inflation strikes. If there is too little, recession and possibly deflation threaten.