What is Inflation?

Learn More About What Inflation Is and How It Affects Your Bottom Line!

 

Although the term inflation may be one of the most familiar words within the world of economics, there are still many people who aren’t fully aware of how inflation works or how it can affect us as individuals. Inflation is a term that is used to describe the general increase in prices and fall in the purchasing value of money, but the truth is, it can be far more complicated than that. Continue reading to learn more about the different types of inflation and why you need to pay attention to them.

 

What is Inflation?

A simple definition of inflation is the constant rise in the price of goods and services.

When the prices for energy, food, and other goods or services rise, our entire economy is affected. Rising prices will often impact the cost of living, the cost of doing business, the cost of loans, mortgages, and every other component of the economy. More often than not, inflation is described and considered to be bad for an economy, but that’s not necessarily true. It’s important to know that inflation is inherently a little unstable and that it can be both beneficial and detrimental to an economy. Moderate inflation can be good for the growth of an economy while hyperinflation often has a negative effect. Hyperinflation means that inflation is occurring at an extremely high rate. To put it simply, if inflation becomes too high, the economy can suffer, but if it is controlled at reasonable levels, the economy may thrive.

 

What Causes Inflation?

There are essentially three ways in which inflation can occur. The first is what many economists call “cost-push inflation”. This is where the cost of running a business rises and that cost is then pushed onto customers through increased prices. If the cost of materials, employees, or land rents increase - many businesses will have no choice but to raise prices to stay in business, even though it can be a risky move.

 

The second kind of inflation is called “demand-pull inflation”. This  is when the number of people who want to purchase a certain product increases past the point of production. The cause of this type of inflation generally comes down to the increase of income and disposable income. For example, the government can cause this type of inflation by lowering taxes, which raises disposable income, which can then raise the demand for a product. That demand will then lead to the rising of prices. We see this same sort of inflation after interest rates have fallen.  Lowered interest rates may offer short term relief when it comes to purchasing power, but it will cause long term inflationary pressure in the future. Say for example the interest rates on loans or mortgages have lowered, leaving you tempted to take out a loan for a new vehicle.  Soon the car companies are going to recognize that there is a solid trend in demand and that they need to raise the prices of their vehicles. This type of inflation tends to be cyclical.

 

The third type of inflation is when governments “print more money”. Governments will often want to stimulate the economy in order to create jobs. In some cases, the printing can be done by literally printing and circulating new notes but, it can also be done by increasing government debt, or by allowing banks to give bigger loans on the same security. In each case, the amount of money that is in circulation increases, which will eventually cause the worth of the individual dollar to fall. The value of the dollar decreases in this case because now there is more money chasing after the same number of things there are to purchase. You may technically have more money, but that money won’t purchase you more in the long term. 

 

How Does This Affect Your Bottom Line?

Purchasing Power

Generally speaking, no matter what kind of inflation is taking place, inflation will affect your buying power. We all know that prices tend to increase over time. For example the average cost of a movie ticket today is around $9, but in the 1950’s the average cost of a movie ticket was $0.49.  With inflation comes a higher cost of living which is something to consider when planning out your financial goals. On the other hand, inflation allows individuals to pay back their loans and mortgages with money that is less valuable than when it was borrowed, which can be considered a benefit. Rising inflation can trigger companies  to offer increased wages which can be good for morale, productivity and the individual's purchasing power if managed properly.

 

Savings, Retirement, and Salaries

If you have any investing or long-term savings goals, inflation is something you will want to be aware of. Over time, inflation can reduce the value of your savings if it outpaces the interest you earn in your savings accounts. In order to combat this, you might consider opening a high yield savings account that can offer you a better-earned interest rate or you may be interested in learning about investments.  You will want to account for inflation when planning out your savings and retirement goals as well as when you are negotiating your salary as it will have a long term effect on your money.

 

Practicing good financial health habits can make the difference between being able to retire or having to work for more years. It’s critical to educate yourself and your family not only on the importance of financial planning, but also understanding how the economy can affect your financial future. To learn more about financial wellness from our Chief Financial Officer, Chief Risk Officer, and Treasurer, Mike Perrino, check out the link below!