‘Inflation’ is a very frequent topic in the study of Economics. Since, economics impact all of our day-to-day lives, so does inflation and its effects. Inflation isn’t the prettiest thing in the world, but it is an integral part of any economy and knowing what it does helps us mitigate its effects.

What is Inflation?

In very simple terms, inflation is the increase in general prices of goods and services in an economy (or a country). In other words, if the price of a loaf of bread is $1 in 2020 and it increases to $1.2 in 2021, we can say that the relevant economy has experienced inflation. What if prices go down? If the price of the same loaf of bread dropped to $0.8 in 2021, we can say the economy experienced deflation or negative inflation.

The monetary and economic policymakers of a country are responsible for maintaining inflation at a low rate. If this gets out of control, a country can experience hyperinflation, which is when prices of commodities skyrocket. Usually, a year-on-year inflation rate of less than 5% is considered desirable.

How to Calculate Inflation

The mathematics behind calculating the inflation rate of a country is rather straightforward. Let’s take the example of the loaf of bread from before. If the price of a loaf of bread increases from $1 in 2020 to $1.2 in 2021, we can say the inflation rate for the year 2020 was 20% (ouch!). You take the difference of the price between two periods (in this case, $1.2-$1=$0.2) and divide it by the base price (in our example, $0.2/$1), and to get the percentage, multiply it by 100.

But when it comes to the practical scenario, no country measures the country’s inflation based on one product. The practical definition of inflation is a ‘GENERAL increase in the price of commodities over a period.’ So, the policymakers pick out a basket of goods and services. Usually, this basket will include essential goods and services so that all of the populations’ needs are captured when measuring inflation. After all, the whole purpose of measuring inflation is to make better economic decisions for the benefit of everybody. This basket of goods might also change from time to time depending on the changing wants and needs of the people.

World Inflation Rates

This is an excellent map by Wikipedia showing the inflation rates of countries all over the world. Data is obtained from International Monetary Fund (IMF) and is accurate as of October 2019.

How is Inflation Caused?

There are two main ways in which inflation occurs in an economy. First, ‘demand-pull inflation’ is when the demand for goods and services grows faster than their supply. For example, if there is a sudden surge in demand for bread all over the country, bakers will not be able to meet this demand instantly. So, the price of bread has to go up to equalize demand and supply. (This is getting into more economics than personal finance at this point!!). When the price of bread goes up, it is called inflation.

Secondly, ‘cost-push inflation’ is when the supply of a certain product drops suddenly thus creating a shortage for the product in the economy. For example, drought or flood could destroy wheat farms thus significantly reducing flour supply which in turn reduces bread production. So, even though the population demands the same number of loaves of bread still, the supply by bakers has dropped. Again, in economics, price is the mediator between demand and supply of a product (in free-market conditions (again, economics)). So, the price increases to make bread more unaffordable to some people thus stabilizing demand and supply.

If an economy considers bread to be an essential good (which most countries do), it cannot be an unaffordable commodity for some people. This is why, governments and policymakers want to keep inflation under control.

The policymakers can artificially control inflation of a country with the control of money in circulation in the economy. This is pure economics at this point so we will not venture into this right now.

If this is too much to comprehend, please do forget it. Next is what is more important for us commonfolk.

Effects of Inflation

There are many economic and social implications of inflation, both good and bad. A very high inflation or a hyperinflation is almost always bad. However, experts do agree that a low and steady inflation is desirable for an economy.

Reduction of Purchasing Power or Losing Value of Money (Bad)

This is the primary complaint against inflation. When prices of goods and services increases, this inadvertently reduces your purchasing power. This means that now you can buy less amount of goods for the same amount of money than you did last year.

Let’s take the same example of bread. In 2020, the price of a loaf of bread was $1 and in 2021, it increases to $1.2, hinting at 20% inflation. Let’s also assume that your annual income is $10,000. So, in 2020, you were able to purchase a grand 10,000 loaves of bread. However, fast-forward to 2021, you can only buy 8,333 loaves of bread. You lost the ability to purchase 1,667 loaves of bread even though you earned the same income. This is called losing the ‘real’ value of money or reducing purchasing power.

Discourages Saving (Bad)

When money loses value over time (as explained above), people will be less motivated to keep money in hand or save in the bank. If the bank interest rate does not match up or surpass the country’s inflation rate (which it doesn’t in almost all cases), you will lose value of money with time. What is to do with money if not for save? Buy more goods or invest.

Encourages Spending (Good-ish)

Since people dislike holding on to money, the first thing they tend to do is spend it on more goods and services. This is more or less an artificial demand, and as we discussed before, an increase in demand for goods if not matched with an equal increase in the supply of goods, causes inflation. So, inflation can cause inflation which is a dangerous place to be.

If you could buy a brand new car for $30,000 in 2020, and the country experiences 2% inflation, by 2021, the same car would be $30,600. You wouldn’t really feel the increase and probably this $600 increase will not rush you to buy the car in 2020 itself. However, if the country had a 20% inflation, the same car would cost $36,000. Now, you would be concerned about saving $6,000 and rush to buy the car in 2020 itself. This creates an artificial demand for the car (when like-minded people do the same), and car production cannot be increased overnight. Thus, this will result in an increase in car price, and eventually in more inflation.

Encourages Investing (Good)

If you don’t want to spend the extra money you have, people will turn towards investing in avenues that can beat the impact of inflation. Simply, the investment returns should be higher than the country’s inflation rate.

For example, a country experiences a 2% inflation rate. You can pick plenty of investment options that can beat 2% on returns or yields. Let’s say you invest $1,000 in dividend stocks with a return of 5%. Let’s calculate the value of your money at the end of one year. Through inflation, the real value of your $1,000 would drop to $980. (Again, the real value is the amount of goods and services your dollars can buy). But now that you earn 5% in dividends, you will gain new money for an amount of $50 at the end of the year. So, all put together $1,000-20+50 = $1,030/= Your money has increased in value. Winner winner!

There are a few more impacts of inflation, but from a personal finance standpoint, these are the most important. You can see how out of the four we listed here, two are considered bad, and two are considered good for the economy. This is why inflation, in some form, is necessary for an economy to grow. And it is a fine balancing act to maintain inflation at an optimal level for the benefit of the people and the growth of the economy.

If you have any questions about inflation, do drop them in the comments below and we will try our best to answer them.