What is Inflation and How Does it Work?

Inflation is something that we have all been hearing in the media recently.

Some have chalked current inflation up to the COVID-19 pandemic, while others have economic foreign policy. The U.S. is currently seeing its highest levels of inflation in over 40 years.

It's crucial that you know what inflation is, because it impacts all areas of the economy, from investment to consumer spending. If you don’t know what inflation is, then you won’t be able to safeguard against it.

This article will break down what inflation is and will explain how it works:

What Is Inflation?

Inflation is the measure of how much the price of goods or services increases over time. As the economy rises, analysts work out a percentage by comparing current economic prices against previous ones. Inflation is worked out by assessing the entire economy, not just specific services and goods like gold and fashion. With that said, inflation doesn’t necessarily mean that the price of everything goes up at the same rate or impacts everybody the same way. Items that don’t typically skyrocket in cost are food and drink, and services like electricity and gas. When food items do rise in price, they seldom rise equally. A chocolate bar’s price will rise faster than an apple’s will.

Cost of Living

Ultimately, inflation impacts people’s cost of living. As inflation goes up, so too does the average cost of living. Some ask, is rising inflation bad? For ordinary people, the answer is yes. A rise in the cost of living can be a massive detriment to a person’s quality of life, especially if they have a low income. Inflation doesn’t always have the same effect on everybody, though. It’s widely known that inflation affects the poor more than it does the rich. In addition, inflation is most detrimental to people who buy products that are rising most. People who don’t buy these products won’t experience the same problems.  

Personal Impact

Lots of young people aren’t concerned with inflation, but they should be. Inflation will affect everybody in one way or another. At the very least, one’s money will be worth less tomorrow than it is today. This can be very problematic for young people who are saving up for their first mortgage or are saving up to buy a car. This is why it’s important to find a savings account that offers an interest rate higher than the rate of inflation. If one cannot find such a savings account, then one’s money will decrease in value.

Financial experts recommend investment accounts, instead of savings accounts. This is because they are very few savings accounts that offer high-interest rates these days. Investing in stock is a good way to increase the value of one’s money long-term. With that said, stock trading can also be incredibly risky. The best way to invest is with a trained investor. Many banks offer investment services to their customers, which can be very useful for first-time investors.

Measurement of Inflation

Lots of people who are new to the concept of inflation are confused by how it is measured when the prices of things rise at different rates. Inflation is measured by special government-appointed agencies, in nearly every country in the world. These figures help to estimate global and domestic inflation figures. The two main ways that inflation is measured are with the consumer prices index [CPI], and the retail prices index [RPI]. The retail prices index looks at the changes in housing by examining mortgage payments. This often means that the RPI’s figure is different from the CPI, which doesn’t take housing into account. The RPI is generally calculated mathematically, while the CPI is calculated geometrically.

Advantages and Disadvantages of Inflation

Advantages

You may be shocked to learn that there are some advantages to inflation. They include:

• Slight inflation allows for wage adjustment. This means that slight inflation allows businesses to increase the wages of productive workers, while unproductive ones can have their wages frozen, which is a wage cut. Wage adjustment is when an employee has their wages increased to match their skills and abilities. This is not possible with extreme inflation, however.

• Inflation can also boost a country’s growth. In times, of low inflation or deflation, the economy will generally be stuck in a recession. A higher rate of inflation can ultimately increase a country’s growth. Targeting higher inflation can help countries to escape from a recession.

• Inflation beats deflation every time. Deflation can be devastating for a country. It can lead to a fall in prices and massive debt, underspending, and a lack of investment. Deflation was the catalyst for the Great Depression. Because of this, inflation is always going to be better than deflation. With that said, inflation can be very problematic and isn’t necessarily desirable just because it's better than deflation.

Disadvantages

• Inflation creates economic uncertainty and lower investment. In periods of inflation, investors are far less likely to make investments in a country and in a country’s companies. This can be devastating for companies that are already suffering the effects of inflation. When fewer people are investing, it can lead to widespread economic uncertainty.

• A person’s savings will fall in value because of inflation, which is also very problematic. This results in people losing huge chunks of their savings. As we mentioned earlier, this can impact young people saving for mortgage deposits. In addition, it can seriously affect older people who are retired and live off of their savings. The only way to counter one’s money being devalued by inflation is to invest, but as we just mentioned, people are reluctant to invest during periods of inflation.

• Lower real wages. As the value of money decreases, if a company doesn’t increase its employees’ wages, then their real wages will be significantly less. This can severely impact a person’s quality of life and can be very financially damaging. In addition, inflation often causes widespread redundancies, which impacts the lives of ordinary people even more.

Inflation is something that everybody has to contend with at least once in their lives. By knowing what it is and what you can do to fight back against it, you will ensure that you don’t end up homeless, unemployed and that your savings won’t be worthless.