Wherever you go, whatever you buy, it’s pretty apparent that prices are rising for many goods and services that Americans purchase. The reason is inflation, but what causes inflation and what can be done about it?

Farmer School of Business economics professors Jonathan Wolff, Nam Vu, and David Lindequist explain the answers to those questions and others.

What is inflation?

Wolff: Inflation is a measure of price growth. Thought of slightly differently, it’s a measure of the rate at which a dollar loses purchasing power. You can discuss inflation as it pertains to a single good or service, but most commonly economists discuss inflation as it pertains to all goods in the economy, a basket of goods commonly purchased by households, or a basket of goods commonly purchased by producers.

Vu: Inflation is a problem when it is higher than a certain level, referred to as the target inflation rate. The target inflation rate is around 2 percent per year. But over the last five or six months, especially if we count food and energy in it, it has been to the tune of anywhere from 7 to 12 percent, depending on how you measure it. And the measure that the media usually cites typically underestimates the actual inflation.

Lindequist: What is really key about inflation is the concept that most or all prices go up at the same time. In the current CPI numbers, not all prices are going up at the same rate, but for inflation to be inflation, many prices increase at the same time.

How is inflation measured?

Wolff: The most common price index reported is called the Consumer Price Index (CPI). The Bureau of Labor Statistics (BLS) will construct a basket of goods that the typical household consumes on a monthly basis, assigning weights based on each item's share of total expenditure. They'll then track changes in the prices of these goods in cities across the country. Growth in this price index gives you a measure of inflation.

Vu: Used car prices are up 40%, but it’s not the same as the measured goods or services because people can spread out some of their payments over a longer term, and they have the option to not buy the car right now or to purchase a cheaper car. But more basic things like food or energy, if it increases by 20 or 30 percent, consumers still have to buy it.

What causes inflation?

Wolff: Inflation can come from a number of different sources. Perhaps the best way to think of it is prices are adjusting to account for a mismatch in supply and demand. Right now, we’re seeing supply chain issues which reduce supply as well as historically low interest rates which increases demand.

The result is large price increases in almost every industry. We're also beginning to see this reflected in wage increases. Year over year, wage growth was up over 5% this year. In a typical year, it would be closer to 2.5 or 3 percent. This reflects both the tight labor market, but also the desire of workers to not see a decline in their real wage as inflation is up over 7% this past year.

Vu: We know the supply chain problems can cause inflation, but there are deeper causes that are associated with the current inflation increases. First of all, because we have been in a boom for the past five years or so, there's a lot of money that’s been saved up by consumers. So that's why price levels have the room to grow. And secondly, people have expected that prices will grow.

So if consumers expect something to happen to make prices increase, consumers are also willing to spend more and companies are more willing to jack up the price. It’s not just the supply chain problems that everybody is talking about -- the bigger issue is expectations. It’s a vicious circle.”

How is inflation stopped or reduced?

Wolff: Macroeconomists have well understood policy tools to combat inflation. However, these tools naturally impact the demand side of the equation. By reducing the amount of liquid assets banks have on their balance sheet, the Federal Reserve changes their ability/willingness to create low interest loans for households and firms, as well as for other financial institutions.

Look for the Fed to continue tapering unconventional policy tools and to begin raising the interest rate paid on reserve balances. Likewise, fiscal policy can slow inflation by slowing debt accumulation. By cutting back on relief spending and stimulus checks, household demand will begin to fall bringing markets back into alignment.

Vu: The government can potentially have policies that alleviate some of the burden from imported goods, policies that work to smooth out the supply chain, because a lot of the goods that you see the increases in price are coming from abroad.

Lindequist: The Federal Reserve has a couple of options. It can generally try to decrease the amount of money that it supplies by stopping asset purchases. The Fed still buys $100B of assets each month, mainly Treasury bonds. So the Fed can try to stop that by slowly winding off buying these assets, and that will reduce the price pressure.

The likeliest thing the Fed will do is start increasing interest rates, which makes borrowing more costly. People will demand less money, hence they will have less money to spend, and that drives down this demand pressure.

Can the process of containing inflation cause other economic problems?

Lindequist: There is the idea that there's a sacrifice to be made to kill inflation -- if you want to bring inflation down, you probably also have to bring unemployment up. Whenever the Fed has raised interest rates in the past, it typically also had some negative employment effects. Sometimes that’s intentional, such as when the labor markets get too hot and you have these wage-price spirals, which basically mean prices go up, then workers demand higher wages. So then wages go up, but then prices go up even further.

Today, this is all a little complicated because why is the labor market hot? It's really because there's a labor shortage. We need people to go back to work, and that hasn't happened yet.

Vu: When actions are taken by the Fed to curb inflation, the biggest potential economic downside is that such an action, if overdone, might depress economic activity, which can lead to a recession. For example, if the Fed increases the interest rate more than needed, it can significantly increase the borrowing cost, which can lead to firms cutting back investments and hiring. When hiring is limited, this typically manifests in sluggish wage growth, depressed aggregate demand, and an overall decline in the economy.

Plus, increased interest rates can lead to the expectation that the economy is not doing well – again, a self-fulfilling prophecy. Such negative expectations can make consumers cut back on large purchases and firms further cut back on investments and hiring. Both of these can have serious consequences for the economy.

Wolff: Since monetary policy can't impact short run supply, a tightening of monetary policy acts to control price growth by reducing demand. This decline in demand will result in a decline in economic activity and thus, an increase in unemployment. Economists actually measure what we call the "Sacrifice Ratio," which measures the percentage of output lost in the process of reducing inflation by one percentage point. 

So ‘correcting’ the labor shortage may manifest as fewer jobs being available until inflation is tamed. These slowdowns sometimes even cause recessions. In the current environment, however, with the economy still off almost 1 million jobs from the pre-pandemic high and labor force participation still rebounding, it’s difficult to say. Employers will normally close searches before engaging in layoffs, as finding and training new workers is quite expensive. So workers who have chosen to remain on the sidelines might find it harder and harder to re-enter.