What is Inflation?
So what is inflation? If you are in constant touch with the financial or commercial world, you must have come across the term; “inflation” before. In this article we shall discuss the meaning of inflation, its causes and effects. We will also be suggesting some ways to operate during inflation periods.
What is Meant by Inflation?
As defined by economists, inflation refers to a financial situation marked by the rise in the prices of economic products and services. A state of inflation also associates a downfall in purchasing power. This mostly takes place when the economic value of a currency drops drastically, leading to a rise in the average price level. So, if you are wondering why a can of your favorite soda costs more than it did ten years ago, inflation has a major role to play behind the rise of its price.
Inflation can affect the economy of a country in several different ways. While its impacts can feel negligible at the moment, it can cause significant changes to the economy in the long run.
Inflation raises the average cost of all products and services. This means inflation can affect all the sectors and not one particular sector. During inflation, there is going to be a rise in the price of food, and even basic services like transport. So, it raises the net cost of living.
As Ronald Reagan, the 40th President of the US once said;
“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hitman.”
However, deflation is a state when there is a fall in the prices of products and services across an economy. In comparison, deflation sounds encouraging. Yet, if left unsupervised, deflations can result in price drops enough to freeze the economy. Together, deflation and inflation play a crucial role in keeping the economy stable.
Are you an investor? And looking to make a profitable investment during inflation periods? Check out our other article on; “How can you Invest Profitably During High Inflation?” and learn more information.
What is Inflation Rate?
Inflation like any other financial phenomenon is measured over a period of time. Inflation rate definition is the rate or the percentage by which the average price of all products or services rises, or falls. The inflation rate is evaluated usually over a month or a year. This inflation rate is also a measure of the rise or fall of the value of a particular currency.
The inflation rate is an indicator of an average individual’s financial health, known as the misery index.1 And since a rise in the average price of goods and services is a significant cause of unemployment, the inflation rate can also potentially predict the unemployment rate. A misery rate of over 10% is suggestive of high inflation in a country’s economy.
Hyperinflation is an extreme economic state when the rate of inflation crosses 50%. When inflation is coupled with recession, it’s known as stagflation.
What Causes Inflation?
There can be several economic reasons that can lead up to inflation. Items listed here are the three most common causes of inflation.
- Demand-Pull Inflation: when there is an excessive supply of money in an economy, it increases the average demand for all goods and services in the economy. So, if the market demands are not met, it leads to a rise in prices causing inflation. This imbalance between demand and supply leaves behind an economic gap, otherwise known as the inflationary gap.
- Cost-Push Inflation: Cost-push inflation takes place when there is a rise in average prices due to production process inputs. Supply of money and assets into an economy followed by economic shocks result in increased prices. These raise the cost of the finished product leading to inflation.
- Built-in Inflation: Often a state of inflation is introduced in an economy in adaptive expectations. As there is a rise in average prices, the working class expects the same rise to continue in the future with a chance of raise in wages. However, the increased wages result in a further rise in prices, therefore an inflationary gap is created.
How can you Measure Inflation?
Inflations are usually measured through price indexes.2 Price indexes used for measuring inflation can be categorized depending on the goods and services. These price indexes are the Consumer Price Index (CPI), Wholesale Price Index (WPI), and Producer Price Index (PPI).2 Other than these most financial and economic websites provide inflation calculators that can measure inflations accurately.
Mathematically, inflation rates are calculated from the initial and final CPI values.
Percent Inflation Rate = (Final CPI Value/Initial CPI Value) *100
What are the Effects of Inflation?
Inflation analyses over the years have suggested that inflation can have both positive and negative effects. These changes, however, become significant over time, depending on the inflationary rates. Businesses involving tangible assets like stocked products and properties can make profits due to high market prices.
However, this would mean the buyers of such products would be paying more than what they usually would have paid. Businesses dealing with commercial bonds may suffer, due to reduced currency values. Speculations about the inflations can also lead to a rise in average prices. Hyperinflations can have major impacts on the economy resulting in serious problems.
However, financial regulators supervise inflationary changes, keeping them in check. These are usually made through monetary policies. The Central Bank’s actions in controlling the rate of the supply of money are also influential in this regard.
During inflations, investors are advised against investing in stocks. This is counterproductive due to raised market prices and additions to the money supply further increase the inflationary rate.
However, investing in bonds is often recommended. Consistent returns on fixed bonds or bond funds can help bridge the inflationary gap. Similarly, investing in Treasury Inflation-Protected Securities (TIPS) that are meant for beating inflations and inflation hedges like gold can be helpful during inflations.
Short-term or long, inflations can impact the economy in several ways. However, understanding how inflations work and taking action can ensure the protection of your assets. With the understanding you have gained from this article, hopefully, inflations will not be worrying you much now that you know how inflations work.
- Wikipedia contributors. (2021, May 14). Misery index (economics). Wikipedia. https://en.wikipedia.org/wiki/Misery_index_(economics)
- Inflation and its Measurement | Explainer | Education. (n.d.). Reserve Bank of Australia. Retrieved June 19, 2021, from https://www.rba.gov.au/education/resources/explainers/inflation-and-its-measurement.html