Have you ever heard about those ‘good old days’ when a cup of coffee was only 25 cents? Or when a beer only cost 50 cents? Then you probably also think that prices have risen dramatically and that we can now buy much less than our parents or grandparents could at our age. But that isn’t the case, because prices rising is in fact a consequence of inflation. So what is this phenomenon exactly, and how does it influence the economy? Let’s examine a fantastic explanation of inflation and recession by Paul Krugman.
Babysitting Coupons
Any currency and country (i.e. monetary region) can experience inflation. But to explain the phenomenon, Paul Krugman uses the example of a babysitting cooperation. The cooperation issued coupons worth 1 hour of babysitting.
When a couple wants to go out they have another couple of the cooperation babysit and pay them in coupons. This way there is always a demand and a supply of babysitting opportunities.
Recession
A recession is a period of time in which there are less coupons being used. In the real world this relates to money being spent. Basically, during a recession there is less business (or in our example, babysitting).
The babysitting cooperation got into a recession when some couples wanted to be able to g out more, so they started saving coupons. This meant there were less babysitting opportunities, which caused the other couples to start saving their coupons. A recession was in place.
Solutions
To fix the recession, there are two things that can be done. The first one is that extra money can be printed, or in our example, more coupons. These would then be distributed amongst the members of the cooperation.
This means they have more hours of babysitting available, so they need to save up less coupons. In short, people will be more willing to spend their coupons again and the cooperation will get out of the recession.
The other solution is inflation.
Inflation
Many people think that inflation is that prices go up. But this is not true. Prices going up is a result of inflation, which is a big difference. Inflation, in fact, is that money deteriorates in value over time. So to compensate, prices go up.
For the babysitting cooperation, the solution to their recession could be to introduce inflation of their coupons. For example, if you have a coupon today, it is worth 1 hour of babysitting. Inflation would mean that the same coupon would only be worth 30 minutes of babysitting a year from now.
When coupons decrease in value over time (inflation), it becomes less interesting to save them up to use on a later date. This means people will be more willing to spend the coupons. Which in turn means there are more coupons circulating, which is good for the economy.
So remember, inflation is the decreasing of the value of your money over time.
March 26th, 2010 at 9:46 am
Bad explanation. Money doesn’t necessarily lose value over time, it only does so if the money supply is increased.
March 26th, 2010 at 11:08 am
Good point, yet in the normal day-to-day life this is exactly what happens. My explanation is not meant as a thorough explanation of all the intricacies regarding inflation. It is merely an explanation of why it exists.