Last Updated on February 28, 2023 by Kel Ashley
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What is Inflation?
Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on a year-on-year basis. It effectively measures the change in the prices of a basket of goods and services in a year.
Inflation occurs due to an imbalance between the demand and supply of money, changes in production and distribution costs or increases in taxes on products. When the economy experiences inflation, i.e. when the price level of goods and services rises, the value of currency reduces. This means now each unit of currency buys fewer goods and services. If this is happening to you, don’t worry our free resource will help you.
What causes inflation?
Economists distinguish between two types of inflation: Demand-Pull Inflation and Cost-Push Inflation. Both types of inflation cause an increase in the overall price level within an economy.
Demand-pull inflation occurs when aggregate demand for goods and services in an economy rises more rapidly than an economy’s productive capacity. One potential shock to aggregate demand might come from a central bank that rapidly increases the supply of money.
Cost-push inflation, on the other hand, occurs when the prices of production process inputs increase. Rapid wage increases or rising raw material prices are common causes of this type of inflation.
How to measure inflation?
Consumers’ cost of living depends on the prices of many goods and services and the share of each in the household budget. To measure the average consumer’s cost of living, government agencies conduct household surveys to identify a basket of commonly purchased items and track over time the cost of purchasing this basket.
The U.S. inflation rate is measured by the CPI, PPI and PCE indexes. Because no single index captures the full range of price changes in the U.S. economy, economists must consider these multiple indexes to get a comprehensive picture of the rate of inflation.
Why does the cost of goods rise over time?
An increase in the price of domestic or imported inputs (such as oil or raw materials) pushes up production costs. As firms are faced with higher costs of producing each unit of output they tend to produce a lower level of output and raise the prices of their goods and services. This can have flow-on effects by pushing up the prices of other goods and services. For example, an increase in the price of oil, which is a major input in many sectors of the economy, will initially lead to higher petrol prices. However, higher petrol prices will also make it more expensive to transport goods from one location to another which, in turn, will result in increased prices for items like groceries.
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How inflation affects the value of money?
The rise in the prices of goods and services and, subsequently, the fall in the purchasing power of each dollar is called inflation. As inflation rises, every dollar will buy a lower quantity of goods.
Inflation is one of the main factors that reduce the value of your money over time. It means that the money you have at the beginning of the year will get you lesser goods and services at the end of the year. As the prices of even basic goods go up over time and during periods of high inflation, even if you carry on with your normal life – eating the same food, travelling to the same places, etc. – either you need to buy smaller quantities, cut down on the total items you purchase or end up spending more.
To combat inflation, you must avoid keeping your money idle (in cash) or in your savings account, which offers negligible interest in real terms. Instead, you must invest your money in investment options where the returns from the investments are higher than the inflation rate.
Investing wisely will not only help you to overcome the problem of inflation, it will also help you achieve your financial goals successfully. Check out our free resource that can help you with this problem.
Conclusion
Inflation means costs and prices are rising. When they do, it means that paper money buys less. Low, steady inflation is good for the economy but bad for your savings.
Aim to structure your portfolio so that it provides a rate of return one that’s hopefully better than, or at least keeps pace with, that of inflation, which is almost always happening. If you do, it means that your investment gains really are making you richer in real terms.