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How Inflation Works

How Inflation Works And How It Impacts The Economy.

By Arsalan HaroonPublished 2 years ago 12 min read
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Edited by the author

Why are homes and other things becoming more expensive than it was 10 or 20 years ago?

The simple answer is inflation.

Inflation means a general increase in the price of goods and services in the nation’s economy.

In the US, the widely used tool to track the inflation rate is the consumer price index published by the bureau of labor statistics every month.

It tracks the prices of goods that an average household buys. CPI is one of the most cited indexes for measuring the inflation rate.

Before we talk about the causes of inflation, Let’s first talk about two extreme cases. In which prices rise too quickly, almost every day, the other where prices don’t increase or start dropping.

Hyperinflation

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High-Inflation can lead to economic disasters, which can cause serious harm to the people and the economy.

When prices start rising every day in an economy, About 100% a day, Which means doubling every day, it is called hyperinflation.

Hyperinflation occurred in Germany between 1921 to 1923.

A loaf of bread which cost around 160 marks at the end of 1922, cost 200 billion marks by late 1923.

Source

It created a shortage in Germany of almost everything because there was more money in the economy than goods to purchase.

The German government printed a lot of money to pay increased wages to striking workers.

These workers have more money than they had in the past without an increase in productivity. So workers will purchase more goods, and as a result, demand goes up faster and more than the supply of goods which causes high inflation.

However, there also were other reasons for hyperinflation. For example, the government started paying down debt by printing new currency, which also caused hyperinflation.

Another example of hyperinflation is Zimbabwe, where prices rose in mid-November 2008 with a rate estimated at 79,600,000,000% per month, which led to the abandonment of its national currency.

The causes of Zimbabwe’s hyperinflation were its government’s printing of money to pay off the rising national debt and a significant decline in economic output, as well as political corruption which worsened the situation in the Zimbabwean economy.

Hyperinflation erodes the wealth of savers because money will be losing value every day.

The winners in hyperinflation are debtors, The borrower will pay less in real terms than they borrowed because the currency will lose value every day.

Hyperinflation encourages people to consume all their income as soon as they receive it because people expect prices tomorrow to rise. It will be unwise for people to save their income.

So when people dont save their income, there will be almost no savings for investment in the economy, which can produce economic growth.

There will be no economic growth if there are no savings because of hyperinflation.

Deflation

Most people think the price of goods decreasing in the economy is good because things will cost less, and they can buy more goods.

But the problem is that as prices start to decline, Everyone will expect prices to fall more, so they stop spending today to buy more goods in the future.

When people stop buying goods and services, It affects the producer of that product as they have less income because consumers aren’t spending.

To cut costs, the company will fire employees because of its lower earnings, Which can lead to higher unemployment and lower economic growth because people aren’t spending.

The effect of deflation is much more harmful because the economy becomes stagnant, which means economic growth in the economy did not occur at all.

Most people see their income start to decrease, or they get fired as deflation rises.

The best case of deflation is Japan’s economy, Economic growth in japan for the last 20 or 30 years has been relatively flat. It didn’t have any economic growth due to deflation.

In Japan, prices of goods started to decrease, which changed expectations as more people expected prices to fall further in the future.

It is a self-fulling prophecy as more people believe that prices will decrease. Demand in the economy would go down, Which leads to a further decline in prices as there is more supply than demand.

When households stop buying products from firms, these firms will get affected, so they tend to fire employees and produce few goods.

It leads to a decrease in the income of all people in the nation’s economy.

In 1995, Japan’s GDP was 5.5 trillion dollars and a per capita income of 44k dollars.

In 2021, Japan’s GDP was 4.9 trillion dollars with a per capita income of 39k dollars.

Japan’s economy isn’t seeing any growth, it has become a stagnant economy, and its GDP and per capita income was decreasing for a couple of decades due to deflation.

That’s why falling prices in the economy are not as good as it seems to most people.

Is Inflation Always Bad For The Economy?

We as consumers don’t want inflation because things will cost more, and we can’t buy as many goods as we used to.

But some level of like 2% is considered healthy for the economy because there is more currency in people’s hands.

Most people will buy more goods, and demand for products increases. If there is more demand than supply, producers will produce more to meet that excess demand, which leads to rising economic growth.

That is why some level of inflation is a good sign for a healthy economy.

What are the Causes Behind Inflation?

Many famous economists studied the causes of inflation and how it affects the economy.

Most economists disagree about the different causes of inflation. There is no straightforward answer to this question.

We will discuss different views proposed by famous economists about the causes behind inflation.

The Modern Quantity Theory of Money

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It was formulated by the Renaissance astronomer and mathematician Nicolaus Copernicus in the 1500s and mid 20 century, later advanced by Anna Schwartz and Milton Friedman, who became famous for their work on the modern quantity theory of money.

In simple terms, the modern quantity theory of money states that an increase in the supply of money with the output (goods and services) remaining the same will increase Inflation.

The quantity theory of money states that the prices of goods are directly related to the supply of money in the economy.

Imagine an economy where there is only one type of good, and there are 100 people each who have one dollar to buy that good. So the money supply is 100 dollars, and if we pump another 100 dollars into the economy while output remains the same.

Everyone will have 2 dollars to spend, and each person will tend to buy more units of that good which will build up the demand, and prices of goods will rise.

When output (goods and services) remains the same, But the supply of money increases, Inflation will occur and will increase the prices of goods in the economy.

Milton Freidman argued that the government should keep the money supply fairly steady, expanding it slightly each year to allow for natural growth in the economy. Friedman famously has said that inflation is always and everywhere a monetary phenomenon.

Today, Central banks like the Fed in the United States or ECB (European central bank) in Europe perform monetary policy and set the target of keeping inflation around 2 to 3 percent to keep the economy healthy.

Although, the modern quantity theory of money is more complex than this.

But avoiding all the jargon and unnecessary details, it simply states that as the government prints more money in the economy while output remains the same, the prices of goods will increase and drive inflation.

Demand-Pull Inflation

Demand-pull inflation occurs when due to an increased supply of money or an increase in government spending, the demand for goods in the economy increases, thus causing demand-pull inflation.

When people have more money in their pocket they will buy more goods, and demand will rise faster than the supply of those goods, thus prices will rise because there will be too much money chasing too few goods in the economy.

Demand-pull inflation occurs when the demand for goods and services exceeds the production capacity.

When firms have excess demand, they tend to hire more workers to produce goods to meet that demand, and the unemployment rate will fall.

When firms produce more and sell them, it also tends to increase the real GDP in the economy. Some level of demand-pull inflation can increase real GDP.

Cost-Push Inflation

When there is a shortage of workers, firms may raise salaries and bonuses to attract new talented employees.

But these increased bonuses increase the cost of production, which would be passed on to consumers in the form of higher prices and cause inflation.

Employees will have more income due to their rise in salary. So they will tend to spend more money to buy more goods, thus increasing the demand for goods. When demand outpaces faster than the supply of products, it causes the prices of products to rise and causes inflation in the economy.

When there is an increase in the costs of production inputs ( raw materials and wages) used for making a final product, It would be passed on to consumers, thus causing inflation in the overall economy.

For example, when the price of oil goes high, it causes high inflation in the economy because oil is the production input for many goods.

Many firms who depend on oil will see the prices of their production input increase due to high oil prices. Then firms will pass those costs onto customers by raising their product prices to stay profitable, and it causes cost-push inflation in the economy.

Cost-push inflation can lead to a high unemployment rate and declining real GDP.

When prices of production inputs, let’s say oil price rise, Then many firms who depend on oil to make their final product will see their cost of production rise.

These companies want to maintain profitability, so due to the higher cost of production, they will cut back on other costs to improve their earnings.

The single most crucial cost to the firm is employees’ wages. So firms will tend to fire or cut wages because their cost of production increased. When firms have fewer workers, they tend to produce less, Which means fewer goods bought in the economy. Therefore a decline in real GDP and high unemployment occur.

Built-in Inflation

Built-in inflation occurs when employees expect prices of goods to rise in the future. They will demand higher wages from their employer to keep up with future inflation.

When firms increase their employee’s wages, It means employees would have more income, so they will spend more to buy a large number of goods because of fear that the prices of those goods may rise in the future. Thus when more people suddenly start buying more goods, demand will increase, and it causes inflation to rise.

This type of Inflation occurs because most people expect prices to go higher in the future.

It is not the reality but the perception of reality that drives inflation.

If more people expect prices to rise in the future, then their actions make the price rise and cause inflation in the economy.

When firms increase wages because of workers’ demand, the firm’s cost of production will increase. It will pass those higher costs to consumers in the form of higher prices, which can cause inflation in the economy. It is a self-fulling prophecy.

Built-in inflation happens because people expect the prices of goods to rise. Then their actions will move the prices of goods to higher levels.

In summary, Demand-pull inflation occurs when demand is so high that production can’t keep up, thus causing inflation to rise.

Cost-push inflation occurs when prices of input (raw materials and wages) used to make a final product rises, then this rise in input cost will be passed on to consumers in the form of higher prices and causing inflation to rise.

Built-in inflation occurs when people expect prices to rise in the future and demand higher wages from their employers. Those extra wages will then buy more goods and increase demand, and firms will pass this higher cost of production to consumers in the form of higher prices, and inflation becomes a self-fulling prophecy.

How To Protect Yourself From Inflation

The best way to protect yourself from inflation is to invest in assets that historically had beat inflation in the long term. It will preserve your real purchasing power or even grow your wealth.

So what investment and asset class have historically beaten inflation?

Some of the investments that historically beat inflation are as follows.

Stocks

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While a single business or a stock may go down. But if you just invested your money into a broad market index like the S&P 500, which has the 500 largest companies in the US, then from 1957 to 2022, the index will have an average return of around 10 with dividends reinvested.

US inflation in the same period was average of around 3.8 percent. You won’t only beat inflation, but also grow your real purchasing power by investing in the stock market.

You can read stock for the long run to better understand why stocks are a better inflation hedge for the long term.

Gold

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Gold is considered by many to be a perfect hedge against inflation to protect your wealth.

Some countries go through periods of high inflation, and their citizens may use gold to protect their wealth.

Whenever there is fear in the financial market that inflation is high, most investors would turn toward gold because its prices usually move higher when inflation is high.

But one major drawback of gold is that, unlike stock or bonds, it’s not an income-generating asset meaning. The only way to get a return from gold is to see price appreciation.

In the long term, stocks or bonds have outperformed the price increase in gold.

From 1990 to 2020, the price of gold increased by around 360%. Over the same, Dow Jones industrial average had gained 991%.

It seems that gold may outperform stock in the short term, but the stock has outperformed gold returns in the long run.

So it is far from perfect, but gold can be a hedge to protect you from inflation.

Bonds

The average annual rate of return on investment grade corporate bonds from 1920 to 2020 is around 5%.over the 30 years.

Corporate bonds have returned around 330% slightly below gold. But over the 15 years, the return on the bonds is lower than that on stock and gold.

Although bonds may protect you from inflation, they won’t grow your purchasing power as much as stocks can.

Which asset class you want to hold depends on your risk tolerance. If you are comfortable taking a risk, you may invest more in stocks than bonds.

Remember, the goal is to find an asset that protects you against inflation and grows your wealth in the long term.

Conclusion

Central banks want to keep an inflation rate of around 2 to 3 percent, Which is considered a reasonable inflation rate to keep pace with real economic growth.

Many economists may differ about the causes of inflation. But the thing is that inflation affects most regular people with fixed income salaries.

When Inflation gets too high, it has a damaging impact on a nation’s economy and its citizens.

So the best way individuals can prepare for inflation is to invest in assets that have historically beaten inflation.

Originally Published on Medium

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About the Creator

Arsalan Haroon

Writer┃SEO Expert┃Investor

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