Why Things Cost More (Inflation for beginners)

Last week I paid almost seven dollars for a dozen eggs. Five years ago I would have paid two. Nothing about the eggs changed. The chickens did not learn a new skill. The cartons did not get fancier. So what happened?

The answer is inflation. And once you understand it, you will see it everywhere. You will know why your grocery bill keeps creeping up, why your raise from work does not feel like a raise, and why your dollar buys less every year even when nothing seems to be going wrong.

Here is the whole thing in one sentence: inflation is what happens when prices rise faster than they should.

A little bit every year is normal. Too much is painful. And it never happens for one reason. It happens because of three forces, all pushing on prices at the same time.

Force one: too much money chasing the same amount of stuff

Picture your neighborhood. There is one grocery store. It has the same amount of food it always has. Now imagine the government sends every household in the neighborhood a check for two thousand dollars.

What happens at the store?

Everyone shows up with more money. They want to buy steaks, ice cream, a few extra things. But the store still has the same amount of food. So the manager does the rational thing. He raises prices. He has to. If he keeps prices the same, his shelves will be empty by noon and there will be a line out the door. By raising prices, he makes sure the food gets rationed by who is willing to pay, not who shows up first.

That is the first force. When more money is floating around than there is stuff to buy, prices go up. Not because anyone is being greedy. Because the math has to balance.

This is what happened during COVID. The federal government sent three rounds of stimulus checks: $1,200 in March 2020, $600 in December 2020, and $1,400 in March 2021. A typical family of four received over $11,000 just from those checks. Add expanded unemployment benefits, the expanded Child Tax Credit, and PPP loans for businesses, and you get one of the biggest cash injections into American households in history.

The intentions were good. People needed help. But the stores, the factories, the supply chains were not producing more goods. They were producing less, because everyone was stuck at home. So you had a giant pile of new money chasing a smaller pile of stuff. The math had to balance. It balanced through higher prices.

Force two: the stuff itself becomes harder to get

Now imagine a different problem. The neighborhood gets no stimulus check. Nobody has extra money. But a hurricane knocks out the road to the grocery store for two weeks. The trucks cannot get in. The shelves start running low.

What happens?

The store manager raises prices again. The eggs that are left have to last. The milk that is left has to last. Even though nobody has more money, the things people want to buy are suddenly more valuable because there is less of them.

That is the second force. When supply gets disrupted, prices go up, even if nothing else changes.

This force is the easiest one to feel and the easiest one to blame. The 1973 oil embargo is the famous example. OPEC cut the supply of oil and the price of gasoline quadrupled. The 2021 supply chain crisis was the modern version: shipping containers backed up at ports, factories in Asia closed, and trucks did not have drivers.

But here is the catch: a supply shock alone usually does not cause years of inflation. It causes a price spike. The spike passes when supply comes back. The reason inflation can stick around for years is because force two often shows up while force one is already happening. The hurricane is bad enough. The hurricane during a stimulus-check shopping spree is much worse.

A fair question: is raising prices during a shortage just gouging?

This is the moment most people stop the economist and say wait, that is not fair. The road is washed out, people need food, and the store owner gets to charge whatever he wants? That sounds like exploitation.

It is a fair question and though I would argue the answer has two parts.

Part one: a price spike during a real shortage is actually doing something useful, even when it feels cruel.

Imagine the store does not raise prices. The first ten customers through the door buy everything they can carry, because at the old price it is cheaper than the value they are getting. By noon the shelves are empty. The eleventh customer, who really needs milk for a sick child, walks home empty-handed. The unfairness did not go away. It just changed from "whoever pays more gets it" to "whoever shows up first gets it." Higher prices force every buyer to ask: do I really need this right now, or can I wait and let someone who needs it more have a chance? They also tell suppliers far away that this town will pay extra to get a truck through. That is how more milk eventually shows up.

Part two: that argument does not give a store a license to charge whatever they want.

There is a real difference between (a) prices rising to reflect genuine scarcity and replacement cost, and (b) a store charging $40 for a $4 bottle of water because customers have no alternative and the owner knows it. The first is how a market handles a shortage. The second is gouging, and most states have laws against it. Florida, Texas, California, and many others can prosecute sellers who jack up prices on essentials during declared emergencies. The legal definition is usually something like "price increases that are not justified by increases in actual cost."

The line between the two is not always easy to draw, but the test most people use is: did the price rise roughly in proportion to the seller's higher cost, or did it rise to capture how desperate the buyer is? A grocer who pays double to truck in milk after a flood and charges 50 percent more is responding to costs. A grocer who triples the price of bottled water during a hurricane because he knows nobody has anywhere else to go is gouging. The first keeps the store stocked. The second is the kind of behavior the laws are written to stop.

So when we say "the store raises prices during a shortage," we mean the first version. It is not the same as price gouging, and it is not what makes inflation persistent. The next force, expectations, is what actually turns a price spike into stuck inflation.

Force three: everyone expects prices to keep rising

Now imagine the same neighborhood, six months later. Word is going around. People are saying eggs are going to be six dollars next month. Milk is going to be five. Gas is going to be five-fifty.

What do people do?

They go buy eggs now. They fill up the freezer. They top off the gas tank even though they have half a tank. They ask their boss for a bigger raise this year because they are going to need it.

The store manager sees the lines and the empty shelves and raises prices. Suppliers see costs going up everywhere and raise their prices to the store. Workers ask for raises and get them because the boss cannot find replacements.

And just like that, the expectation that prices will rise becomes the cause of prices rising. Nothing about the supply changed. Nothing about the money changed. The belief itself moved the dial.

This is the hardest force to fight, because once people believe prices will keep rising, they act on the belief and prove themselves right. Economists call it "un-anchored expectations." I just call it the part where inflation gets stuck.

What it cost to break the loop: the Volcker years

The most famous example of breaking that loop happened in the United States in the late 1970s. Inflation had been climbing for years. People stopped believing it would ever come back down. They asked for bigger raises. Businesses raised prices in advance. The whole thing was spinning.

In 1979, a new chairman took over the Federal Reserve. His name was Paul Volcker. He was tall, blunt, and famously stubborn. He looked at the situation and decided the only way to break the cycle was to make money so expensive to borrow that the economy would slow down on its own. So he raised interest rates. And then he raised them again. And then again. By the early 1980s, the rate the Fed controlled was approaching 20 percent.

Here is what that meant in real life. When you buy a house, you usually borrow most of the money from a bank. The bank charges you interest on what you borrowed. The interest rate the bank charges follows what the Fed does. When the Fed pushes rates up, so does the bank.

In October 1981, the average rate on a 30-year mortgage hit 18.63 percent. That was the highest in American history. It is still the highest today.

Think about what that meant for an ordinary family. On a $100,000 mortgage at 18.63 percent, the monthly payment was around $1,560. On the same loan at the rate we saw during COVID (about 3 percent), the payment is about $420. Same house. Same loan. Almost four times the cost just because of the interest rate.

Did everything get more expensive, or only borrowing?

This is where most explanations of the Volcker era get sloppy, so it is worth slowing down.

Did prices fall during Volcker's medicine? No. Prices kept going up every single year. They just went up slower. Here are the actual numbers:

• 1980: prices rose 13.5%
• 1981: prices rose 10.3%
• 1982: prices rose 6.2%
• 1983: prices rose 3.2%

This is an important distinction. Disinflation is when the rate of price increases slows down. Deflation is when prices actually fall. Volcker caused disinflation. He did not cause deflation. A loaf of bread in 1983 still cost more than it did in 1982. Just not 13 percent more, like it had a few years earlier.

So if you were paying cash for groceries, gas, and rent, you still felt prices going up the whole time. The pain was easing, but it was real.

The much sharper pain hit people who needed to borrow money. Here is why:

• Homebuyers got it worst. Mortgage rates over 18 percent meant the same house was suddenly unaffordable. Many families who wanted to buy simply could not.
• Existing homeowners with variable-rate mortgages watched their monthly payments balloon. Some lost their homes because they could no longer make the payment.
• Car buyers faced auto loan rates of 17 to 20 percent. Car sales collapsed.
• Small business owners could not borrow to expand. Many closed.
• Farmers, who borrow heavily every spring to plant crops, were devastated. The 1980s farm crisis foreclosed tens of thousands of family farms.

Meanwhile, people with money in the bank were doing fine. Bank accounts and CDs were paying 12 to 15 percent interest. If you were retired and living off savings, the high rates were actually good for you.

So the answer is: Volcker's medicine did not lower prices. It just slowed how fast they rose. But the side effect of the medicine, the high interest rates, did most of the damage. Whole industries that depended on borrowing got crushed. The grocery shopper had it bad. The would-be homebuyer had it much worse.

Look closely at the chart and you will notice something interesting. Inflation peaks in March 1980. But mortgage rates do not peak until October 1981, a full year and a half later. Then once inflation starts falling, mortgage rates fall too, but more slowly. Why?

Three reasons. First, the Federal Reserve only began clearly easing once they could see inflation actually coming down, not just because they hoped it would. They wanted proof before they let off the brake. Second, mortgage lenders set 30-year rates based on what they expect inflation to do over the next 30 years, not what it is doing today. Even with inflation falling, lenders did not yet trust that the drop would last, so they kept rates high as insurance. Third, the bond market that ultimately determines mortgage pricing simply moves slowly. It takes time for a multi-decade product to reprice.

This is force three (expectations) doing its work in reverse. It took months for the expectation that prices would keep rising to fade, even after the actual rises had slowed. That is why central bankers fear letting expectations get loose in the first place. Bringing them back is slow and expensive.

This was the medicine. It worked. By 1983, inflation was down to 3.2 percent and people started believing prices would stay stable. But the bill was paid by the people who needed loans, especially anyone who wanted to buy a home or a car or build a business. (Also read: When AI Breaks the 30-Year Mortgage) That generational scar is part of why so many people still remember the early 1980s as an economically painful time, even though grocery prices were finally calming down.

This is the trade-off every central bank now lives with. If you let force three get out of hand, the only cure is enormous pain. That is why the Federal Reserve was so aggressive about raising rates after 2022. They had seen what happened the last time inflation expectations got loose, and they wanted to crush it before it got that bad. Whether they raised them fast enough, or too fast, is something economists will argue about for the next twenty years.

One more thing about housing: people buy on the monthly payment, not the price

There is a quiet truth about housing that the Volcker chart hints at but does not say out loud. When mortgage rates fall, home prices tend to rise to absorb the savings. People do not buy a house based on the sticker price. They buy based on what they can afford to pay each month. When the bank says you can borrow more for the same payment because rates are lower, you compete with everyone else doing the same thing, and the price of the house climbs to match.

After rates fell from their 1981 peak, U.S. home prices jumped 42 percent between 1984 and 1988. Between 1998 and 2006, with rates hovering in the 5 to 8 percent range, prices doubled in many markets. Then mortgage rates hit a record low of 2.65 percent in early 2021, and the median U.S. home price rose another 30 percent in just two years.

So the "good news" of falling rates often turns into the "bad news" of unaffordable homes. The monthly payment stays roughly the same. The size of the loan you need to take on grows. The wealth gap between people who already own homes and people who are trying to buy their first one widens with every rate cycle. This is one of the most consequential and least-discussed effects of inflation policy, and it explains a lot of why housing has felt impossible for younger generations even when rates were historically low.

Putting all three together

Inflation is almost never one force. It is the three of them working together.

Force one (too much money) is usually the starting point. Force two (supply problems) decides how bad it feels in the short term. Force three (expectations) decides how long it lasts.

If you want to know what is happening to prices in any given moment, ask the three questions: Is there a lot of new money in the economy? Is something making it harder to produce or ship goods? Do people expect prices to keep rising?

If all three answers are yes, you get something like 2021 to 2023. If just one is yes, you get a price spike that passes. If none are yes, you get the boring 2 percent inflation the Federal Reserve aims for. That is what a healthy economy looks like.

So why does any of this matter to me?

Because inflation is not bad luck. It is the predictable result of choices, mostly made by the government and the Federal Reserve. When you understand what causes it, you understand why your money is buying less, and you can make better decisions about saving, spending, and the policies you support.

You also stop falling for the easy answers. Every political season, someone will tell you inflation is happening because corporations got greedy, or because workers got lazy. Those claims describe symptoms, not causes. The real causes are the three forces. Whoever tells you a different story is usually trying to sell you something.

Here is what really gets people: it is not the single bad year of inflation. It is the way it compounds. Two percent a year sounds harmless. But two percent a year, every year, for a hundred years, eats almost everything.

A dollar from 1913, when the Federal Reserve was founded, buys about three cents of stuff today. The other ninety-seven cents have vanished into inflation. The Federal Reserve targets about 2 percent inflation per year specifically because they think a small, steady decline in the value of money is healthier for the economy than perfectly stable prices. Over your lifetime, that small steady decline adds up to a lot.

This is why understanding inflation matters. If your savings sit in cash earning nothing, you are getting poorer every year even though the number in your account stays the same. If your salary goes up 2 percent a year, you are running in place. The only way to actually build wealth over time is to own things that grow faster than the rate at which the dollar shrinks: real estate, businesses, stocks, sometimes precious metals or other hard assets. People who do not own these things are slowly squeezed out, year after year, by a system most of them do not understand.  (NOTE: This is why our MartyMath calculators always include an inflation variable, such as in the FIRE calculator - try it yourself and see the impact of inflation on your retirement.)

I built a free tool that lets you play with all three forces yourself. You move the dials, watch the prices in a grocery cart react, and see how the forces combine. It takes about five minutes. You can find it at Inflation: Three Ways to Learn..

The short version is simple. Prices rise when too much money meets too little stuff, especially when people start expecting it to keep happening. That is most of what you need to know to understand the headlines for the rest of your life.

Key Takeaways

• Inflation means prices are rising over time. A little (about 2% a year) is normal and healthy. A lot is painful.
• Three forces cause it: money, supply, and expectations. Almost every inflation episode in history is some combination of these three.
• The COVID-era inflation was mostly force one. The government and Federal Reserve put trillions of new dollars into the economy, but the economy was producing less. The result was the highest inflation in forty years.
• Supply problems alone usually cause short spikes, not years of pain. What turns a spike into stuck inflation is when force one or force three are already in motion.
• The hardest force to fix is expectations. Once people believe prices will keep rising, they act on it, which makes it come true. Paul Volcker's Federal Reserve had to push mortgage rates to over 18 percent in 1981 to break the loop. The cost was a recession and millions of lost jobs.
• People buy houses on the monthly payment, not the sticker price. When mortgage rates fall, home prices rise to absorb the savings. This is why decades of falling rates produced today's housing affordability crisis even when rates were historically low.
• Inflation compounds. Two percent a year sounds harmless. Over a century, it eats 97 percent of the dollar's value. A 1913 dollar buys about three cents of stuff today.
• You do not need to be an economist to see this. Once you know the three forces, every news story about prices makes more sense.

FAQ

What is the Federal Reserve and what does it actually do?

The Federal Reserve, usually called "the Fed," is the central bank of the United States. Its main job is to keep prices stable and unemployment low. It does this mostly by raising or lowering interest rates. When inflation is too high, it raises rates to slow down borrowing and spending. When the economy is too weak, it lowers rates to encourage borrowing and spending. It does not set tax policy or government spending as those are set by Congress.

Why is some inflation considered good?

A small amount of inflation, around 2% a year, gives the economy room to breathe. It encourages people to spend or invest money instead of hoarding cash that is losing value. It makes it easier for businesses to give raises without cutting other workers' pay. And it gives the Federal Reserve room to lower interest rates in a recession without hitting zero. Zero inflation sounds nice but usually means the economy is too cold.

What is deflation and why is it bad?

Deflation is the opposite of inflation: prices falling over time. It sounds great, but it usually causes the economy to freeze. If you think a TV will be cheaper next month, you wait to buy it. If everyone does that, stores cut back, factories slow down, people get laid off, and the economy spirals down. Japan has struggled with deflation for thirty years. Most economists agree mild inflation is the lesser of two evils.

How does raising interest rates fight inflation?

When the Federal Reserve raises rates, it becomes more expensive for banks to borrow from each other. That cost gets passed on to consumers in the form of higher mortgage rates, car loan rates, and credit card rates. Higher rates make people borrow less, spend less, and save more. With less money chasing goods, prices stop rising as fast. The trade-off is that high rates also slow down hiring and can cause a recession if pushed too hard.

Why does my paycheck not keep up with inflation?

Wages tend to lag behind prices. Employers usually adjust salaries once a year, while prices change every day. So if inflation jumps from 2% to 7%, your raise is probably still based on last year's 2%. You lose ground in real terms even if your number goes up. Over time, wages catch up, but during a sudden burst of inflation, most people feel poorer because they are poorer.

Is raising prices during a shortage the same as price gouging?

No, but the line is real and worth understanding. When a hurricane wipes out supply and a store raises prices in proportion to its higher costs and the genuine scarcity, that price spike is doing useful work. It rations the limited supply, prevents the first ten customers from clearing the shelves, and signals far-away suppliers that this market will pay extra to ship more goods in. Price gouging is different. It is charging far more than costs justify because customers have no alternative, and most U.S. states have laws against it during declared emergencies. The rough test: did the price rise to cover the seller's higher costs, or did it rise to exploit how desperate the buyer is? The first is how a market handles a shortage. The second is illegal.

Why were mortgage rates over 18% in the 1980s?

The Federal Reserve, led by Chairman Paul Volcker, had to crush inflation that had been building for over a decade. The only way to do that was to make borrowing extremely expensive, so people would stop spending and businesses would stop raising prices. In October 1981, the average 30-year mortgage rate hit 18.63 percent, the highest in U.S. history. It worked. Inflation dropped from 13 percent to under 4 percent in three years. But the cost was a brutal recession, a collapsed housing market, and a generation of homeowners locked into double-digit payments. For comparison, mortgage rates hit a historic low of 2.65 percent in early 2021 and currently sit around 6 to 7 percent.

What is the difference between disinflation and deflation?

Disinflation means prices are still rising, but slower than before. Deflation means prices are actually falling. They sound similar but they feel very different. During Volcker's tightening from 1980 to 1983, the U.S. experienced disinflation: inflation dropped from 13.5% to 3.2%, but prices kept going up the whole time. Japan in the 1990s experienced true deflation, where a TV that cost 100,000 yen one year might cost 98,000 yen the next. Disinflation is what central banks try to engineer. Deflation is what they try to avoid.

Why do mortgage rates lag behind inflation?

Mortgage rates respond to inflation, but slowly. There are three reasons. First, the Federal Reserve only eases rates once it sees confirmed evidence that inflation is dropping, not just hopeful signs. Second, mortgage lenders set 30-year rates based on what they expect inflation to do over the entire life of the loan, not just today. They want to be compensated for the risk that inflation might come back, so they keep rates high until they trust the drop. Third, the bond market that prices mortgages takes time to digest new information about a multi-decade product. As a rule of thumb, mortgage rates can lag a major change in inflation by 6 to 18 months in either direction.

When mortgage rates fall, do home prices go up?

Usually yes, and the reason is buyer behavior. People decide how much house they can afford based on the monthly payment, not the sticker price. When rates drop, the same monthly budget can support a bigger loan, so buyers compete for the same houses at higher prices. The price floats up to absorb the rate cut. Every major rate-cutting cycle in the United States has been followed by a home price surge: 42 percent gains in 1984-1988 after Volcker's rate cuts, a doubling in 1998-2006, and another 30 percent jump in 2020-2022 when rates hit historic lows. The unfortunate side effect: housing affordability rarely improves much from rate cuts alone. The benefit gets captured by the price of the house.

How much purchasing power has the U.S. dollar lost over time?

A lot. A dollar from 1913, when the Federal Reserve was founded, buys about three cents of stuff today. That is roughly a 97 percent loss in purchasing power over 110 years. Most of that loss happened after 1971, when the U.S. dollar was taken off the gold standard. The Federal Reserve targets about 2 percent inflation per year, which sounds small but compounds: at 2 percent annual inflation, a dollar loses about half its purchasing power every 35 years. This is why putting money in a savings account paying less than the inflation rate guarantees you will get poorer over time, even though the number in the account grows.

About the Author

Martin Goetzinger has spent his career in enterprise software sales, helping large organizations such as Apple, Microsoft, and Verizon connect data, insight, and action. His work focuses on transforming how businesses measure success and create customer value through technology.

Outside the enterprise world, he writes about the five forces he believes are reshaping everything: AI, blockchain, energy, personalized health, and robotics. Not from a purely technical lens, but from a human one as to how these technologies will redefine work, wealth, and well-being.

He is based in the U.S. and publishes at www.MartinGoetzinger.com.

Disclaimer

The views expressed in this article are the personal opinions of the author and are provided for informational and educational purposes only. Nothing in this article constitutes investment advice, financial advice, legal advice, or any other form of professional advice. Do not make investment or financial decisions based on the content of this article. Always consult a qualified professional before making decisions that affect your finances, business, or livelihood.