The "full faith and credit" of the United States government backs the money supply. This means that the government's ability to tax gives the backing of all of the goods and services in the economy to the Federal Reserve's bank notes. This allows the Federal Reserve to easily expand the supply of money, which in turn causes inflation. This ability to inflate the money supply also creates distortions in the distribution of income.
Process of Inflation
A central bank, such as the U.S. Federal Reserve banking system, introduces new money into circulation when the central government issues bonds and the central bank purchases them. This process causes inflation of the supply of money, and the introduction of new money continues so long as the government continues to issue bonds and the central bank continues to buy them.
Problem of Inflation
Inflation becomes a problem when the amount of money in circulation exceeds the demand for that money. This occurs when the production of goods remains the same or reduces in comparison to the growing amount of money in circulation that people use to purchase those goods.
This continuing increase in the money supply then causes the prices of these goods to increase. For example, when there's more money in circulation, baking companies may bid the price of flour higher, which in turn raises the cost of bread at the grocery store.
This process makes goods more expensive than they otherwise would be if inflation did not also affect incomes. Generally, wages also go up with inflation, since companies will have more money to spend on quality workers.
Effects on Income
When inflation occurs, it also affects income. The effect on income can vary according to those industries on which inflation has the most effect. If a person's income rises faster than the rate of inflation, a growth of income still exists in real terms; if a person's income rises at the same rate as inflation, no actual increase exists; and if a person's income lags behind inflation, then goods in the economy appear more expensive and a loss of income exists in real terms.
Disadvantages for Income Distribution
This effect on income also has an effect on the distribution of income, which in turn affects standard of living. Those with well-paying jobs or incomes that exceed inflation receive more income than those who only keep pace with inflation, and those whose incomes keep pace with inflation receive income that those with incomes that lag behind inflation do not receive. This creates real inequalities in the distribution of income as even productive individuals can see a reduction in their standard of living if they do not receive an increase in income that at least matches inflation.