Inflation has consequences for us all, and we need to understand it. We all feel the effect of inflation whenever things get more expensive and our hard-earned money don’t get us nearly as far. This can affect every part of your life from food to fuel. The higher the inflation rate, the more your savings will evaporate.
Understanding inflation helps you make better financial decisions – it will teach you how to save, invest and spend. Therefore, it is very important to really understand the concept of inflation to protect your money and form strategic long term financial planning.
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The Main Causes of Inflation
The leading causes of inflation are either too much money chasing too few goods or increasing import prices.
1) Too Much Money Chasing Too Few Goods
If there is more money in the economy than there are goods and services to buy, prices will go up as people compete for scarce resources. This inflation is called demand-pull inflation.
2) Import Prices Increasing
If the costs of imported goods and services increase, inflation can follow since businesses are then making consumers pay more to receive these goods and services. This inflation is called cost-push inflation.
Inflation, though sometimes helpful in stimulating economic growth, can also damage an economy. The rise in inflation can lower the value of money and raise interest rates and unemployment.
What Are the Effects of Inflation?
Inflation influences an economy in different ways:
1) It Reduces the Value of Money
As costs rise, every currency unit represents a lesser quantity of goods and services. This is money depreciation or deflation.
2) It Leads to an Increase in Interest Rates
Inflation will decrease the value of money, so people will save more and spend less. It will drive up interest rates, because companies will want to entice customers by offering them more for their savings.
3) It Increases Unemployment
As businesses charge more and the price increases, consumers have less to spend. It can result in a fall in demand for products and services and a rise in unemployment.
How Inflation Is Calculated
Inflation is calculated by statisticians using a representative sample of goods and services and plotting changes in price over time. Statisticians use this to derive an inflation rate, a measure that expresses how much prices have fluctuated in a given time. To arrive at an accurate figure, statisticians determine inflation rate every year.
Inflation rate is usually expressed as a percentage and calculated by statisticians with the following formula:
Inflation Rate = [(Price of Goods and Services in Current Year – Price of Goods and Services in Previous Year) / Price of Goods and Services in Previous Year] x 100
For example, if the price of goods and services in 2018 were 10% higher than in 2017, the inflation rate would be 10%.
Ways To Protect Yourself From Inflation
There are a few ways to protect yourself from inflation.
- Save money in a currency that doesn’t fluctuate like the US dollar or the Japanese yen.
- Invest in something not directly related to the level of prices, like gold or land.
- Reduce your expenses and live within your means.
- Save for retirement in an inflation-proofed manner, such as by holding inflation-protected securities.
In Summary
Inflation can be positive or negative for people and economies. While you can try to fend off inflation’s ill effects in some ways, you have to pay close attention to the effects on your life. You also need to keep yourself up to date with current inflation rates in order to make smart money decisions.
Disclaimer – This list is solely the author’s opinion based on research and publicly available information.