How the Federal Reserve regulates inflation
1. If the total amount of currency circulating increases faster than the total value of goods and services in the economy, each individual piece will be able to buy a smaller portion of those things than before. This is called inflation.
2. On the other hand, if the money supply remained the same while more goods and services were produced, each dollar’s value would increase, in a process known as deflation.
3. So which is worse? Too much inflation means that the money in your wallet will be worth less tomorrow, making you want to spend it today. While this stimulates business, it also encourages overconsumption or hoarding commodities like food and fuel, raising their prices and leading to consumer shortages as well as more inflation.
4. But deflation makes people want to hold on to their money. The decrease in consumer spending reduces business profits, which leads to more unemployment and a further decrease in spending, causing the economy to keep shrinking.
So most economists believe that while too much of either is dangerous, a small consistent amount of inflation is necessary to encourage economic growth. The Fed uses vast amounts of economic data to get the numbers just right in order to stimulate growth and keep people employed without letting inflation reach disruptive levels.