Inflation is a critical economic concept that affects everyone, from consumers to investors and businesses. It represents the gradual erosion of purchasing power due to rising prices of goods and services over time. While moderate inflation is often viewed as a sign of a growing economy, excessive inflation can disrupt financial stability and planning. This blog delves into the types of inflation, how it is measured, its causes, and strategies to protect your finances during inflationary periods. By understanding inflation, you can make informed decisions to safeguard your purchasing power and investments.
What Is Inflation?
Inflation is the gradual attenuation of purchasing power-that is, an overall increase in the level of prices of goods and services over time. The inflation rate is determined through the measurement of how much the average price increases of a basket of goods and services in one year. High inflation means that prices are rising rapidly, whilst low inflation means that prices are growing at a slow rate. Conversely, deflation occurs when prices are falling and create an upward surge in purchasing power.
Types of Inflation
Demand-pull inflation
This occurs when, due to an increase in the money supply and credit, total demand for commodities and services increases, a reflection more than the economy can produce. When there is money circulating, consumer sentiment increases, therefore consumer spending increases. This reflects on how demand is higher than supply, increasing prices.
Cost-Push Inflation
Cost-push inflation arises whenever raw materials or commodities' prices increase, hence making cost go up because production becomes expensive. All these cost increases are eventually passed downstream to consumers in the prices of goods and services. For example, speculative increases in oil prices translate into energy cost increases. The high energy cost then translates to higher consumers' cost and eventually boosts inflation.
Built-in Inflation
This type of inflation is derived from the idea that the prevailing rate of inflation will be maintained. As prices keep going up, workers will naturally demand wages to maintain their standard of living. More and more wages go into higher production costs, and an upward spiral continues to feed and fuel higher prices-the wage-price spiral.
How to Protect Your Finances During Inflation
There are many ways people can protect their money from inflation. One such strategy is to invest in asset classes that have a history of performing well when inflationary periods are on the horizon. Such asset classes include commodities such as oil, natural gas, electricity, and agricultural products like grain and beef. Commodity prices generally rise ahead of general product prices, making commodity prices a good leading indicator of inflation. In fact, commodities are volatile because the natural disasters, political events, and wars affect the price of these commodities.
Investment in real estate also provides protection against inflation because a landlord raises rents to maintain the pace with rising prices. TIPS are U.S. Government Bonds developed to protect purchasing power by keeping track of the inflation rate, so investment in TIPS is possible.
How is inflation measured?
Then, using that information, statistical agencies figure out what the current value of a "basket" of goods and services is; the basket contains goods and services that households typically consume. That number constitutes a price index. To calculate inflation rates over time, statisticians take that value, cross-reference it to different periods, and calculate a rate of inflation from one period to another. Comparing values month-to-month produces the inflation rate on a monthly basis, while comparisons over a year provide an annual inflation rate.
The Consumer Price Index in the United States is published by the Bureau of Labor Statistics. This indexes the costs of items purchased by urban consumers. That index is reported at the level of regions as well as nationally. Finally, the Personal Consumption Expenditures price index, published by the U.S. Bureau of Economic Analysis, covers a wider range of consumer expenditure-related categories, including healthcare, and is weighted based on data collected from business surveys.
Advantages and Disadvantages of Inflation
Advantages
- Asset Value Increase: Individuals with tangible assets (like property or commodities) priced in their home currency may benefit from inflation, as it raises the price of their assets, allowing for higher selling prices.
- Increased Speculation: Inflation can encourage businesses and individuals to engage in riskier projects and invest in stocks, anticipating better returns than inflation.
- Encouraged Spending: A moderate level of inflation can promote spending over saving, as the purchasing power of money decreases over time, incentivizing people to spend now rather than later. This increased spending can boost economic activity.
Disadvantages
- Higher Costs for Buyers: Inflation can lead to higher prices, making it more expensive for consumers to purchase assets. Those holding cash or bonds may find their real value eroded.
- Need for Inflation-Hedged Assets: Investors concerned about inflation should consider assets like gold, commodities, real estate investment trusts (REITs), and inflation-indexed bonds to protect their portfolios.
- Economic Costs of Uncertainty: High and variable inflation can create significant costs for businesses, workers, and consumers, as they must adjust their buying, selling, and planning decisions based on rising prices.
- Increased Research Costs: The uncertainty introduced by inflation can lead to higher costs in terms of time and resources spent on estimating and adjusting economic behaviors, detracting from real economic fundamentals.
- Distorted Price Signals: Even a stable, predictable inflation rate can cause serious economic issues due to the timing and distribution of new money entering the economy, leading to a sequential change in prices (the Cantillon effect) that distorts relative prices, wages, and rates of return.
- Economic Imbalances: Economists generally agree that distortions of relative prices away from their equilibrium can harm the economy, with some Austrian economists viewing this process as a significant driver of recession cycles.
What Causes Inflation?
Now, there are three basic causes behind inflation: demand-pull inflation, cost-push inflation, and built-in inflation. Demand-pull is the inflation where excess demand for products and services creates an upward pressure on prices. The higher production cost incurs cost-push inflation, forcing businesses to increase their prices. Built-in inflation is also known as a wage-price spiral. The process occurs when higher living costs necessitate the demand for wage increases by the laborers, lest they fall behind. Companies react to rising wages by increasing prices on their commodities, causing a vicious cycle of spiraling wages and prices.
Is inflation good or bad?
Excessive inflation has been proved detrimental to the economy since under-inflation can also be harmful. Many economists opine that ideal inflation lies in the low to moderate rate of 2% per annum. This rate is optimal and encourages spending and investment without eroding purchasing power too much.
This appears to 'hurt' primarily savers, as the future purchasing power of their saved money is less because it suffers higher inflation and thereby reduces further what they can buy. The borrower's debt, in a way, becomes cheaper to repay over time because the real value of money has decreased and so can be used to service debts at a price lower than when he borrowed it. This interplay between the saver and the borrower in an inflationary environment is complex.
Conclusion
Inflation is a double-edged sword, bringing both opportunities and challenges. While it can erode purchasing power and increase living costs, it also encourages spending, investment, and economic growth when maintained at moderate levels. Protecting your finances during inflation requires thoughtful strategies, such as investing in inflation-hedged assets, commodities, and real estate.
One such investment option is Compound Real Estate Bonds (CREB), which offers an 8.5% APY, fixed income, and anytime withdrawals. Backed by real assets and U.S. Treasuries, CREB provides a stable, inflation-resistant income stream, making it an ideal choice for those looking to preserve and grow their wealth in uncertain economic times. Planning your financial future with inflation in mind ensures long-term stability and peace of mind.
