Personal Finance
Lesson 10
4 min

What is inflation?

Here are some things that you need to know about inflation to better understand the economy we live in and your personal financial situation. 

  • Inflation means that you get less for the same amount of money you needed before.

  • The reason behind demand-pull inflation is increasing demand due to higher private and government spending.

  • Cost-Push inflation happens because of a price increase during manufacture of goods that ultimately increases the market price to buyers. 

  • Built-In inflation leads to rising prices as a result of suppliers raising their prices because inflation-linked labor contracts with their employees force them to raise wages, leading to a “price/wage inflationary spiral”.

  • However, there are many theories and sometimes opposing views about what actually causes inflation and its effects on the economy.

  • In today’s scientific view, the mainstream agreement is that inflation depends on the growth of the money supply relative to economic growth - inflation is the result once money is “printed” faster than it is demanded.

  • An extreme form of inflation is hyperinflation which can happen when governments create too much money.

In this lesson, you are going to learn about inflation and why it matters to investors.

What is inflation?

In simple terms, inflation measures the rate of price increase in the economy for general goods and services. It is not just individual goods or services, everything you can buy rises in price. As prices increase around us, a certain amount of money will allow you to purchase fewer services and goods than before. Such a development impacts the general cost of living for many of us and can become a problem when it leads to the deceleration of economic growth. 

Causes of inflation

Throughout history, the economy has been subject to periodic economic changes caused by inflation as a result of numerous factors. The reasons and effects of inflation are disputed. Some popular distinctions are: Demand-Pull inflation, Cost-Push inflation and Built-In inflation. Don’t be discouraged if this sounds too difficult - here is a simple explanation of each. 

Demand-Pull inflation

Put simply; this type of inflation is a result of an imbalance between demand and supply. In detail, demand-pull inflation happens when the total demand for goods and services by the public is much higher than the supply of said goods and services. This creates a gap - if many consumers want to buy certain goods, this results in higher prices and, in the end, leads to an overall higher cost of living for everyone. This is the most common cause of inflation.

This development often happens during an economic upswing. A rise in employment in an economy means more disposable income to the general public, which leads to higher spending. This increase in demand ultimately leads to a rise in the price of goods and services. 

In simple terms, inflation measures the rate of price increase for general goods and services in the economy.

Cost-Push inflation

This is the result of an increase in price during the production or manufacture of goods. If goods cost more to manufacture, this ultimately increases the market price for buyers. For example, a company has to increase the labour cost of manufacturing their sunglasses by hiring more employees and getting more expensive materials. Since the company had to pay a higher cost for the production of the sunglasses, they increase the market price in order to make a profit from selling them. 

Built-In inflation

On the other hand, “built-In inflation” occurs when prices in an economy rise and workers expect higher wages in order to support their cost of living. This causes a slippery slope of problems because higher wages lead to higher demand, higher demand leads to higher market prices which results in, you guessed it, inflation.

Why inflation is important for those holding cash 

Inflation can be seen as a good or bad thing, depending on your position. Inflation may not mean positive news for those who only save cash in their bank account, as inflation devalues their cash holdings. ie, your funds end up with less purchasing power and won’t generate returns if the rate of inflation is higher than the interest rate for the savings account.

Why inflation is important for those who invest 

Inflation often favours those who invest. Investors with tangible assets such as stocks or commodities hope for inflation in markets that affect their investments as it increases demand and they can then sell for a higher price. In turn, buyers of said assets would have to spend more money on what was once a lot cheaper. Like you learned in lesson 7 on How to start budgeting for investing, you should invest a fixed monthly amount of your disposable income in financial products of your choice to avoid your savings being the target of inflation.

 
 
 
 

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FURTHER READING 

BOOKS

  • Donovan, Paul - The Truth About Inflation

  • Samuelson, Robert J. - The Great Inflation and Its Aftermath

US consumer sentiment rises along with inflation expectation

Services, energy drive euro zone March inflation higher

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