Inflation is defined as an increase in the general price level, which reduces the purchasing power of money, causing you to buy fewer goods and services for the same amount of money. Inflation should ideally be kept low because it is thought to promote long-term economic stability.
The price of certain goods and services can increase during periods, which can be due to many reasons. But this is not inflation. For it to be classified as inflation, the general price level in the country is raised and stays this way over a longer time. But what causes inflation? What types of inflation risk do economies face? How can it affect our everyday lives? Below, we discuss everything you should know about inflation.
Why Inflation Happens
Inflation can occur for many different reasons and the main driving factors can be different in different economies. Here are some of the main reasons why inflation is rising:
- The central bank of a country pumps out large amounts of money into the economy. If the central bank starts to “print” too much money, there will also be too much money in circulation which means that the purchasing power and value of the national currency is eroded.
- Another inflation risk is significantly increased demand. When there’s a supply-demand, companies do not have time to produce enough goods. Companies then see an opportunity to increase prices and may also need to do so due to higher production costs. The underlying reasons may be, for example, that average wages have risen or that the market prices of an asset that is important to society have increased, such as fuel and housing.
- The development of the world’s stock exchanges is largely driven by what people think will happen in the future. If the media and experts daily report that inflation is about to rise, employees may demand higher wages to compensate for the price increases. Inflation can thus be driven up solely because there’s speculation and concern about increased inflation.
How Much Inflation Is Normal?
Inflation occurs in all market economies and sometimes it’s even desirable. The most important thing for a healthy economy is that inflation is at a reasonable level and stable. Both too high and too low inflation are problematic.
Excessive inflation can lead to large variations in prices and supply, which is something that leads to uncertainty in the economy. Inflation that is too low, on the other hand, might lead to deflation, in which the general price level falls. It can and has also historically led to problems for the affected economies.
However, high inflation can be favorable for those who have many loans or a large loan. When inflation increases, money becomes less valuable, meaning that loans also become less valuable. The same applies to savings that are in a regular account.
Consequences Of Inflation
Inflation means consequences that can be difficult to avoid. Among other things, inflation can lead to consumers and banks not spending in the same way because uncertainty is high, which can damage economic production in the long run. As we mentioned above, inflation can, for example, be beneficial for a consumer when inflation erodes the value of a loan for borrowers.
People living on lower incomes are particularly affected by reduced purchasing power, which can lead to a lower standard of living in the long run.
Hyperinflation occurs when inflation exceeds 50% per month, leading the entire economy into a deep crisis. The capital markets stop operating, and foreign investors and companies take their money and leave the country.
This ends up worsening the situation even more and the country’s currency quickly becomes worthless. In such situations, people, for good reason, no longer trust the country’s currency and might even switch to direct barter.
To avoid such a scenario, central banks all around the world are closely monitoring inflation, a task that has also become the main priority of monetary policy.
How Is the Inflation Rate Calculated?
Inflation is calculated by comparing the consumer price index (CPI) from the previous year and that of the current year. The CPI is a measure of the average price level of consumer goods.
Another frequently cited index that calculates the inflation rate in the US is the Personal Consumption Expenditures Price Index (PCE).
Inflation can be good and bad news, depending on your point of view and life situation. For people who live on a fixed income, higher inflation rates can dilute the purchasing power of their money while for those who owe a debt, inflation can make their debt easier to pay.
As inflation affects everyone, it’s crucial to know the basics and learn how to protect your financial assets from the rising prices that inflation brings.
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