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What is inflation? How does inflation work? (2022)

If you feel like your dollar doesn’t go quite as far as it used to, you don’t imagine it. The reason is inflation, which describes the gradual rise in prices and slow decline in purchasing power of your money over time.
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trangtran.c98
9 min read
Published Aug 25 2021
Updated Mar 25 2024
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What is inflation? 

Inflation is the loss of a currency's purchasing power caused by changes in the average price of the chosen products and services over time. Due to inflation, more money is required to buy the same goods and services.

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Various things can generate inflation. Supply chain problems, penned-up consumer demand, and the pandemic's economic boost have all had a role in the current spike in inflation, at least in some parts.

How does inflation work? 

The chief measures of inflation commonly include these factors:

Consumer Price Index (CPI).
Producer Price Index (PPI).
Personal Consumption Expenditures Price Index (PCE).

They all utilize numerous metrics to monitor changes in what consumers spend and what producers get across all sectors of the economy.

Although it can be discouraging to realize that the dollar's value is steadily declining, most economists view a tiny bit of inflation as a positive indicator of a robust economy. A reasonable inflation rate encourages people to invest or use their money now rather than burying it beneath their mattresses and watching it lose value.

If inflation is let to spiral out of control and increase significantly, it can become a destructive force for an economy. Uncontrolled inflation has the potential to destroy an economy. One of the most notable examples is Venezuela, where in 2018, the inflation rate reached over 1,000,000% each month, wrecking the economy and pushing numerous citizens to leave the nation.

Causes of inflation 

Inflation is caused by a rise in the supply of money, albeit this can happen through a variety of economic factors. The monetary authorities can boost a nation's money supply by:

The quantity theory of money

Lax monetary policy often leads to prolonged periods of high inflation. A currency loses unit value when the amount of money in circulation exceeds the size of the economy.

As a result, its purchasing power decreases and prices increase.

Pressures on the supply or demand side of the economy

Demand-pull inflation: Such as a rise in the stock market or expansionary policies. When the central bank increases government expenditure or lowers interest rates to keep up with demand, prices rise as a result. This may momentarily increase overall demand above what the economy can sustainably produce.
Cost-push inflation: Occurs when businesses are forced to raise prices due to an increase in the cost of producing goods and services.

Built-in inflation

Happens when employees demand raises in pay to meet up with increased living expenses. A self-reinforcing cycle of salary and price rises results from businesses increasing their pricing to cover their rising wage costs.

Pros and cons of inflation

Pros

Inflation, in theory, aids in boosting output when the economy is not operating at full capacity, i.e., there is unused labor or resources. In order to encourage spending to some extent rather than conserving, an ideal level of inflation is frequently suggested. A larger incentive to spend now rather than saving and spending later may exist if the buying power of money decreases with time.

Greater money translates into increased spending, which translates into more total demand. More output is therefore required to satisfy increased demand. Spending may rise, which could stimulate economic growth in a nation. A balanced strategy is believed to maintain the inflation value at an ideal and desirable range.

Inflation was required to avoid the Paradox of Thrift, which says that if consumer prices are allowed to constantly decline because the nation is growing too productive, customers will learn to put off their purchases in order to wait for a better deal. This paradox has a net effect of decreasing aggregate demand, which causes a decrease in output, job losses, and a deteriorating economy.

When borrowers repay debts with money that is less value than the money they borrowed, inflation also makes things simpler for them. This promotes lending and borrowing, which again boosts expenditure overall.

Cons

People will have to pay more money due to inflation. Inflation may reduces the true worth of people assets. Thus, those want to hedge their portfolios against inflation should think about investing in commodities, real estate, gold, and other inflation-hedged asset classes. Another way for investors to profit from inflation is through bonds that are inflation-indexed.

High and erratic inflation rates can have a significant negative impact on an economy. When making any economic decisions, all entities must take the effects of generally rising costs into consideration which leads to the uncertainty to the economy because they run the risk of estimating future inflation rates incorrectly.

Every time new money and credit enter the economy, they always go into the hands of particular people or businesses, and as they spend the new money as it moves from person to person and account to account throughout the economy, the process of price level adjustments to the new money supply continues.

Inflation does cause some prices to rise first and other prices to rise later. The Cantillon effect, which describes the sequential shift in prices and purchasing power, demonstrates how inflation affects relative prices, salaries, and return rates in addition to raising overall prices over time.

In general, economists are aware that distortions in relative prices that are outside of their economic equilibrium are bad for the economy. This process is a major contributor to economic downturn cycles.

How to control inflation

The crucial duty of regulating a nation's financial system includes controlling inflation. It is accomplished through putting policies into effect through monetary policy, which describes the activities taken by a central bank or other groups to control the amount and rate of the money supply expansion.

The Federal Reserve's (FED) monetary policy objectives in the United States include moderate long-term interest rates, price stability, and maximum employment, all of which are meant to support a stable financial environment. In order to maintain a constant long-term rate of inflation, which is believed to be advantageous to the economy, the Federal Reserve makes its long-term inflation targets apparent.

Businesses can prepare for the future because they know what to expect when prices are stable, or when inflation is at a reasonably consistent level. The FED is of the opinion that this will encourage maximum employment, which is based on non-monetary factors that change over time and are hence subject to change.

Because of this, the FED doesn't set a clear target for maximum employment; instead, it primarily depends on what companies think. Full work does not equate to zero unemployment because there is always some cyclicality when people quit and start new careers.

In the worst economic circumstances, monetary authorities also adopt extraordinary steps.

For instance, the U.S. Fed has maintained interest rates close to zero and conducted a bond-buying program known as quantitative easing in the wake of the 2008 financial crisis. The program's detractors claimed it would lead to an increase in the US dollar price, although inflation peaked in 2007 and gradually decreased over the following eight years.

The most straightforward argument is that the recession was a highly noticeable deflationary environment, and quantitative easing supported its effects. There are numerous intricate reasons why QE did not cause inflation or hyperinflation, but this is the most straightforward one.

American officials have worked to maintain inflation at a rate of roughly 2% annually. Aware that deflation may spread throughout the eurozone and cause economic stagnation, the European Central Bank (ECB) has also pursued aggressive quantitative easing. As a result, certain regions have seen negative interest rates.

Additionally, nations with faster growth rates may tolerate more excellent inflation rates. Brazil strives for 3.5%, while India's target is roughly 4% (with a maximum tolerance of 6% and a minimum tolerance of 2%) (with an upper tolerance of 5% and a lower tolerance of 2%).

Hedging Against Inflation

Stocks

As the increase in stock prices includes the consequences of inflation, stocks are regarded as the best hedge against price increases. Since bank credit injections through the financial system are how nearly all modern countries increase the money supply, a large portion of the immediate impact on prices occurs in financial assets that are valued in their native currencies, such as equities.

Additionally, one might employ specialized financial tools to protect investments against inflation. Treasury Inflation-Protected Securities (TIPS), a low-risk Treasury instrument that is indexed to inflation, are among them. With TIPS, the invested principal is boosted by the rate of inflation.

A TIPS mutual fund or an ETF based on TIPS are additional options (ETF). You'll probably need a brokerage account to gain access to stocks, ETFs, and other investments that can help you guard against the risks of inflation.

Although it doesn't always seem to be the case but looking backward, gold is seen as a hedge against inflation.

Avoid hoarding cash

It's crucial to invest and avoid holding too much cash so that your money doesn't lose too much of its worth.

However, inflation means that over time, your money will likely buy fewer things. Which indicates that in order to prevent a decrease in purchasing power, you should spend a fixed amount of money to invest in various things during the following economic cycle.

Diversify your portfolio

Having a well-diversified investment portfolio is another strategy to get ready for inflation. When you spread your investments over several asset classes (stocks, bonds, cash, real estate, etc.), industries, and nations, you can increase investment returns while also lowering risk, such as that from inflation.

FAQs about inflation

Is high inflation a problem?

A healthy economy is facilitated by low and consistent inflation. Each year, the UK government sets a target for the amount that prices should rise overall. The desired percentage is 2%. The Bank of England is responsible for maintaining inflation at that level.

A small amount of inflation is beneficial. However, inflation that is too high or unsteady can be damaging. People find it challenging to plan how much they can spend, save, or invest when prices are uncertain.

In extreme circumstances, high and unstable inflation can bring about the demise of an economy. Zimbabwe is a prime illustration. This occurred between 2007 and 2009, when its price level rose by about 80% in a single month. People simply refused to use Zimbabwean banknotes as a result, which caused the economy to collapse.

How policymakers deal with inflation?

In order to reduce inflation, the appropriate set of disinflationary policies must be considered. If central banks are committed to maintaining price stability, they can pursue contractionary policies that limit aggregate demand in an overheating economy. Typically, this involves hiking interest rates.

With different degrees of success, some central bankers have decided to enforce monetary discipline by fixing the exchange rate, which ties the value of their currency to that of other currencies and, in turn, ties their monetary policy to that of another nation. Such initiatives, however, could not be helpful when international rather than domestic factors cause inflation.

When worldwide inflation in 2008 increased due to high food and fuel prices, several nations let the high global prices trickle down to the domestic economy. The government may occasionally establish pricing in these situations (as some did in 2008 to prevent high food and fuel prices from passing through).

Such administrative price-setting procedures typically lead to the government accruing substantial subsidy bills to compensate for producers' income losses.

As a weapon for reducing inflation, central bankers depend more and more on their capacity to affect inflation expectations. To simulate the inflation-related component of expectations, policymakers proclaim their intention to maintain low economic activity temporarily. The greater the credibility of central banks, the more impact their statements have on inflation expectations.

Can you beat inflation with gold?

Although there is still considerable disagreement on this claim, many investors believe gold is the best inflation hedge.

For instance, the price of gold climbed by 7.6% annually between April 1968 and June 2020. Its average return at3.6% after inflation is taken into account. However, gold's value fell by 28% and 12%, respectively, in 2013 and 2015, indicating that it is not the reliable, safe method some belief it to be.

The price of gold can fluctuate significantly over time and is influenced by changes in the value of other currencies, decisions made by the Fed and other central banks regarding monetary policy, and irregular supply and demand.

Additionally, investing in gold has a unique set of difficulties. You must locate a safe place to store gold with additional charges if you purchase gold. Gold is subject to a higher long-term capital gains tax rate than stocks and bonds when sold after being held for a year or more.

Conclusion

Overall, the economy benefits from a modest increase in wages and inflation. It is a sign of a developing country that is continually adjusting its economic policies to serve the needs of its people and its international partners.

After all, a country needs to adapt if it wants to avoid global inflation risks. Only if we have a solid financial strategy for the future will we be able to deal with the negative consequences of inflation.