Understanding Inflation - Part 1
This month, we are starting a blog series tackling a different subject affecting our finances in four parts. We will look at these topics more in-depth each month over four weeks.
In this month’s blog series, we will focus on inflation. We’ll talk about what inflation is, how it is caused, and how it affects us. We’ll also provide some actionable ideas on how to hedge against inflation in investing, personal saving, and cost-cutting.
We all know exactly what inflation is. It’s the general increase in prices of goods and services over time. It is often measured as the percentage change in the price level of a basket of goods and services, known as the Consumer Price Index (CPI)1. That means inflation affects almost all aspects of the economy, including wages, investments, and borrowing.
The question, long on everyone’s mind, is how and why inflation is so high right now. A number of factors, including supply and demand imbalances, changes in the money supply, and changes in production costs, cause inflation. Prices increase when the demand for goods and services exceeds the supply. On the other hand, if the supply of goods and services is greater than the demand, prices tend to fall.
Changes in the money supply can also cause inflation. If the central bank prints too much money, more money will be chasing the same amount of goods and services, causing prices to rise. Similarly, if the supply of money remains constant, but the velocity of money increases (meaning that people are spending money faster), then inflation can occur.
Changes in production costs can also contribute to inflation. For example, if the cost of raw materials, labor, or energy increases, then the cost of producing goods and services will also increase, and this cost will be passed on to consumers in the form of higher prices.
All this sounds logical enough, right? Until you find yourself at the gas pump paying over $4.00 a gallon! But believe it or not, inflation isn’t always bad, even though it is bad right now.
Inflation can have both positive and negative effects on the economy. One of the positive effects of moderate inflation is that it can encourage people to spend their money now rather than save it for later. This can help to stimulate economic growth and create jobs. It can also help reduce government debt's real value, making it easier for governments to pay off their debts.
However, as we know, high or persistent inflation can negatively affect the economy. One of the biggest negative effects of inflation is that it reduces the purchasing power of money. When prices rise, people can buy fewer goods and services with the same amount of money. This can lead to decreased living standards, especially for people with fixed incomes or low wages. And these are all things we are dealing with right now.
High inflation can also lead to economic instability. When prices rise too quickly, it can cause businesses to raise their prices to keep up with inflation, leading to a cycle of inflationary spirals. And high inflation can also cause people to lose confidence in the economy and the currency, leading to a decrease in investments and a decrease in economic growth.
Central banks often use monetary policy tools such as raising interest rates or reducing the money supply to combat inflation. Central banks can slow down the inflation rate by making it more expensive to borrow money or reducing the amount of money in circulation. However, these measures can also negatively affect the economy, such as reducing economic growth and increasing unemployment.
In conclusion, inflation is a complex economic phenomenon that can positively and negatively affect the economy. While moderate inflation can stimulate economic growth and reduce the real value of government debt, high or persistent inflation can reduce the purchasing power of money, lead to economic instability, and decrease confidence in the economy and the currency. Central banks can use monetary policy tools to combat inflation, but these measures can also negatively affect the economy.
If you found this blog helpful and think your friends and family can benefit, we encourage you to share it with them. Next week, we’ll discuss how different investments can help preserve your savings against inflation.
Sources:
1 Inflation: What It Is, How It Can Be Controlled, and Extreme Examples
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in the price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.