What is Inflation?

What is Inflation?

Inflation is the increase of an average price of a specific basket of goods in an economy during a specific period of time.

Due to a rise in the price of the goods, a unit of currency buys fewer units of the goods than the currency did prior to the increase in price. Therefore, the currency loses its purchasing power.

The opposite of inflation is deflation.

Why is Inflation Important?

In every community, people need a number of basic goods and services in their daily lives.

For survival, people need food products such as water, grains, vegetables, fruits, and meat or fish. They also need healthcare services.

People need fuel to power their homes and vehicles.

For communication and entertainment, people need phones and Internet services.

If the prices of these goods and services increase, and the average wages in the general population do not increase, then the purchasing power of the population diminishes. The cash in their pockets, the currency in their bank accounts, loses value.

Inflation is essentially a tax. It is a tax on the cash sitting in their bank accounts.

Let’s say a loaf of bread costs $2. And then the price of the loaf of bread increases by 25% to $2.50 per loaf.

This means $2 can no longer buy a loaf of bread. This implies that $2 has lost its ability to buy a loaf of bread. It has lost its purchasing power.

This lost purchasing power increases the cost of living of people. People will have to spend more on bread, which will reduce the amount of money available for savings and investments. It will also reduce the amount of money available to buy other products.

This can reduce overall consumer spending and investing, which can lead to a slowdown in the overall economy.

The Central Bank and Inflation

Inflation is generally caused by an increase in the supply of money in the economy.

The supply of money is the responsibility of the central bank of a country. Central banks set and implement monetary policy to manage the supply of money in order to keep inflation at around 2% per year.

The central bank can increase the money supply by using different methods. The central bank can:

– Instruct the country’s Treasury to print more money to be offered to individuals and businesses.

– Provide loans via reserve account credits to banks in the banking system. These banks can in turn loan the money to individuals and businesses.

– Buy government bonds from banks in the secondary market to lower bond interest rates and provide liquidity to these banks for the banks to extend more lower-interest loans to individuals and businesses. This is called quantitative easing.

– Devalue the currency artificially. This normally only occurs in a country where the currency is pegged to a fixed exchange rate. Then, the central bank can change the exchange rate to reduce the value of the currency.

Monetary Policy

By controlling the supply of money, the central bank is responsible for managing inflation through its monetary policy, which sets the size and rate of growth of the supply of money.

In the United States, monetary policy related to inflation is the responsibility of the Federal Reserve.

In Canada, monetary policy related to inflation is the responsibility of the Bank of Canada.

The Bank of England, Reserve Bank of Australia, European Central Bank, and other central banks manage inflation in their countries.

A central bank uses its monetary policy to establish stability and a certain level of certainty in its local economy by communicating long-term inflation goals to the public. The objective is to maintain an inflation rate at about 2% per year and allow for steady and manageable growth in an economy.

The central bank can increase interest rates to reduce the money supply since it becomes more expensive to borrow and invest or spend money.

Or the central bank can reduce interest rates to increase the money supply since it becomes less expensive to borrow and invest or spend money.

Why Does the Supply of Money Cause inflation?

If a central bank instructs its Treasury to print too much money, which causes a higher volume of money and credit to become available to individuals and businesses, then this increased amount of money goes into the marketplace to buy a limited number of goods and services.

Therefore, there will be a large amount of money chasing a small number of products. This will increase demand which will cause an increase in the prices of these goods and services.

In addition, the economics of supply and demand apply to a currency just like to any other product. An increase in the supply of money reduces the value of money already sitting in bank accounts.

This is inflation. But there are a few different types of inflation, which are categorized based on their causes.

Demand-Pull Inflation

Demand-pull inflation is the type of inflation described above. It occurs when there is an increase in the supply of money in an economy. This increases the amount of money chasing a limited supply of goods, which causes prices to increase.

This inflation is caused by a demand pull.

Cost-Push Inflation

Cost-push inflation occurs when there is an increase in the cost to manufacture a product and this cost is passed on to consumers in a higher price for the product.

For example, let’s say there’s a sudden shortage of crude oil due to political instability or war in the territory of a large oil-producing nation that supplies oil to other countries. This will cause an increase in oil prices. The cost of producing any product that uses crude oil as a raw material will increase. This could include products from housing insulation material to electronics such as smartphones. This cost will be passed on to consumers in a higher price for the product.

Built-In Inflation

Built-in inflation is the notion that people expect that over time the prices of goods and services will and should increase.

For example, a tenant expects that his landlord will increase his rent each year. An employee expects to receive a wage increase each year of at least the rate of inflation of 2% to 3% per year. This will enable the employee to keep pace with the increase in prices of goods and services so the employee can continue to afford these goods and services.

As such, there is a built-in expectation of buyers and sellers that the prices of goods and services will and should increase, which causes sellers of these goods and services to increase their prices, and buyers expect to pay these increased prices.

How Inflation is Calculated

A select basket of goods and services that is meant to track common spending categories is used to calculate the price indices of inflation.

The 2 most popular price indices are:

1. Consumer Price Index (CPI)

Consumer Price Index calculates the weighted average of prices of a basket of consumer goods and services in transportation, food, and medical care.

CPI calculations take the changes in retail prices of each item in the basket and average them based on each item’s relative weight in the basket. CPI is monitored, calculated, and reported each month.

Inflation Rate % = (Final CPI Value/Initial CPI Value)*100

2. Producer Price Index (PPI)

Producer Price Index calculates the average change in sale prices received by domestic producers of intermediate goods and services.

PPI may be calculated at the level of the commodity, sector, or economy.

When Inflation is Good

Every nation wants its economy to grow. But not too fast and not too slow. A steady increase in prices of goods that matches an increase in wages is a good thing for an economy.

If an economy is growing and people are receiving higher wages, then it is expected that the prices of goods and services should increase over time. It indicates that the economy is growing as its people become richer.

If you’re a seller of goods, you want your prices to increase over time.

When Inflation is Bad

On the other hand, an increase in prices of goods that outpaces an increase in wages is not a good thing for an economy.

People become poorer as their purchasing power decreases. They have to give a higher number of units of currency to receive the same number of units of goods.

And the currency they have in their bank accounts loses its value.

Speculation

Human beings are inherently greedy. People constantly overreach. When they have too much money, they often act irrationally.

If there is an increase in the money supply due to the monetary policy of a central bank, this excess money will seek both consumer goods as well as higher-return investments.

Investors will seek to earn returns that are higher than the inflation rate. This often leads to increased investment in speculative assets or risky businesses.

An example is the increased investment in volatile cryptocurrencies and meme stocks while people were at home during the Covid-19 pandemic in 2020.

The government had offered stimulus cheques to people. The banks had offered low-interest credit to people. And people were no longer spending cash on transportation to work or on entertainment at bars and restaurants.

Therefore, their excess cash was channeled into high-risk and high-reward cryptocurrencies and meme stocks as investors chased down high returns. This led to huge profits for a few investors and huge losses for other investors.

Excessive Consumption

If inflation is high, and people expect the inflation rate to increase, they know that the purchasing power of the cash sitting in their chequing and savings accounts will decrease, and their cash will lose value.

As such, as mentioned above, they may invest in high-risk assets to get higher returns. And they may also overspend on goods and services today since they expect these goods and services to be more expensive tomorrow.

These goods and services depreciate in value over time. Cash spend on these depreciating goods will reduce the amount of cash in savings and investments, which is important in building wealth.

Inflation Hedge

If the prices of goods are increasing, your wages are stagnant, and your cash in the bank is losing its purchasing power, what can you do to protect yourself against inflation?

You will need to invest in assets that provide a return on investment at or higher than the rate of inflation:

Gold

The most popular hedge against inflation has always been gold. Gold is an asset that has been used for decades to store and preserve wealth.

The price of gold is relatively stable and trades within a predictable price range over time. As such, in times of uncertainty such as high inflation, investors turn to gold as a safe haven. They exchange their cash or other assets for gold.

You can invest in physical gold bars or gold securities such as gold mutual funds and gold exchange-traded funds.

Blue Chip Securities

If the prices of goods are increasing, then large established blue-chip companies that sell these goods benefit from these increases in price. And their stock prices rise with their good fortune.

You can invest in the stocks of these companies to ride their wave of good fortune with them.

In addition, an increase in the money supply inevitably finds its way into stocks of large public companies, which also increases their stock prices. You can benefit from these increasing stock prices too.

Inflation-Indexed Securities

Financial institutions have created financial securities that are specifically designed to hedge against inflation. You can invest in:

– Treasury Inflation-Protected Securities (TIPS), which are low-risk Treasury securities that are indexed to the rate of inflation. The  principal amount invested is increased by the inflation rate. For more diversification, you can invest in TIPS mutual funds or exchange-traded funds.

– Inflation-indexed bonds, which are bonds that are indexed to the rate of inflation.

Foreign Currencies

If you live in a country with high inflation and your local currency is decreasing in value precipitously, you can exchange some of your currency in your bank accounts for foreign currency of a stable country with lower inflation .

During periods of high inflation, many investors buy currencies such as Swiss Francs and U.S. dollars to hedge against inflation in their local economy because these two currencies are relatively stable.

The U.S. dollar is the world’s reserve currency, which makes the U.S. dollar more abundantly available for purchase than the Swiss franc. A reserve currency is the foreign currency that is held in large amounts in the accounts of central banks around the world as part of their foreign exchange reserves. The reserve currency is used by the central banks for international transactions and investments.

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