What is Inflation? And Why It Matters

We recently published an article titled Inflation’s Back, and It’s Going to Get Bad

In it, we talked about reports that show that consumer prices went up 4.2% in April 2021, which is the fastest since 2008. We also talked about how inflation affects the price of stocks quite a bit and can have a very, very big impact on the economy as a whole. While we urged patience, what we didn’t do was take the time to explain just exactly what inflation is. So here we are!

Inflation can be described as the rate of the general increase in the price of a set of goods and services in a given period, usually one year. It measures how a set of goods and services have become much more expensive over one year. A general economic view insists that an excess money supply maintains long-term inflation. 

In this sense, inflation can be viewed from both positive and negative viewpoints measuring the overall effects of changes in prices of a chosen set of goods to represent a single figure that shows this price increase. If you’re confused then don’t worry! Let’s talk about how inflation is measured and why it even matters to you in the first place (hint: it does matter!).

Don’t care about inflation and just wanna start investing today? You can find videos and help with investing over at the Wealth Stack app. Download it for free today.

How is Inflation Measured?

To measure inflation, economies try to identify commonly consumed commodities and services called a basket of goods and services. It is calculated through a measure called a price index. 

Some of the most commonly used are: Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

Consumer Price Index (CPI)

This is calculated as the change in prices of the items in the basket of goods and services and averaging them against the respective weights they carry. In doing that, you’ll then have a weighted average. 

The prices in use are those of commodities purchased by individual households on a retail basis.The basket of goods is adjusted occasionally in line with the changing consumption patterns but is kept constant, more or less.

Wholesale Price Index (WPI)

This measure of inflation focuses on the prices of commodities at the producer or wholesale level before they get to the retail level. These are goods sold among business organizations, wholesalers, and manufacturers and are traded in bulk quantities.

What are the Causes of Inflation?

The root cause of inflation is the general increase in money supply in the economy through monetary policies. The money loses its value, and this can be classified into the following;

Demand-Pull Inflation

This type of inflation occurs when there is an increase in demand for products by consumers. This increase in demand leads to a supply shortage because households are willing to spend more of their incomes on purchasing commodities and services. 

As unemployment levels drop, households have more disposable income to spend. More jobs are created to boost production, increasing income disposal. Eventually, an excess demand for products outpaces the manufacturers' ability to supply, ultimately leading to inflation.

This can be significantly enhanced by free government spending, increased demand for exports, increased money supply in the system, robust economic growth, and future price increase expectations by companies who withhold supply to create demand.

Cost-Push Inflation

Cost-push inflation occurs when there is an increase in the cost of production. This leads to a general rise in the overall prices of commodities. These costs translate from high prices on raw materials and wages, which reduce aggregate supply passing the cumulative cost down to the final retail consumers.

Cost-push inflation occurs when the demand for the product remains the same over this period of increase in the cost of production to manufacturers. It is often caused by unprecedented natural calamities such as earthquakes, wildfires, floods, and tornadoes. These unexpected events bring damage to manufacturing facilities causing partial or total damages. Following this, production costs will likely rise to cater for the previous damages.

Inflation, however, has its benefits and drawbacks depending on the viewpoint of the affected individual or business. For example, in our article mentioned above, we talked about how inflation was going to affect the prices of copper, which affect home construction and a whole slew of other activities.

Are There Benefits of Inflation?

While inflation is usually touted as something pretty negative, there definitely can be benefits of inflation. Here are just a few.

Economic Growth

Low inflation levels may keep an economy stagnated in a recession. Although this opinion is controversial, targeting higher inflation levels could push the economy back to a boom as households would now spend more because they’re expecting a future increase in prices of goods and services.

Deflation Countermeasure

Deflation increases the actual value of debt. Households would withhold spending on goods and services during deflation. This is because they perceive future falls in prices of those commodities and they would be cheaper.

Adjustment of Wages

Optimum inflation levels lead to a relative adjustment of real wages due to increased production. This is great for workers (and even greater for millennials, who are suffering from stagnant wages).

Price Adjustments

Some economists believe that a continued increase in prices is a good way to keep businesses profitable and curb deflation. 

What Are the Biggest Drawbacks of Inflation?

As mentioned, most people view inflation as bad. And, it certainly can be. The four biggest drawbacks of inflation include: discouraged investors, unstable economic growth, low living standard, and decreased purchasing power.

Discouraged Investors

A high uncertainty of the future regarding the value of current investments may deter investors from actively investing in the economy. That’s no good for anybody, but especially not young investors looking to learn how to build long-term wealth.

Unstable Economic Growth

Economic booms supported by inflation tend to be unsustainable because stricter controls would push the economy back to recession as households work to try and cut back spending.

Low Living Standards

Inflation can make a country’s exports uncompetitive in the global market. All this does is reduce their national income along with the general living standards of the households and people living in that country.

Decreased Purchasing Power

Inflation can also decrease the purchasing power of households that pay and receive income based on fixed interest rates. For example, pensioners' purchasing power would fall as they continue to receive the same payment over time, even with inflation. Prices are rising but because they’re receiving the same dollar amount, it doesn’t stretch as far.

How Do You Control Inflation?

Each country appoints financial regulators who are charged with keeping the economy in check, normally federal reserves and central banks. They use different policies to control inflation depending on the cause of the inflation. These are both fiscal and monetary policies.

Monetary policies are the measures pursued by the regulator to control the money supply to achieve economic growth sustainability. These measures can either be contractionary or expansionary. These tools include interest caps, minimum reserve requirements, and management of expectations of the market.

On the other hand, fiscal policies are the measures taken to control the levels of government expenditures and tax rates to influence the economy. Its tools are taxes and spending.

The regulators work to promote a stable financial economy, which ensures a steady rate of inflation over time. Inflation, therefore, can result in both positive and negative economic effects to a country and should therefore be kept in constant check to maintain economic stability.

Should You Invest While Inflation’s Increasing?

Our answer to this is the same answer we had in the previous article tackling how bad inflation is in 2021. Don’t be fully invested and be sure to have some cash stashed away. If you’re younger, you don’t need to be as conservative with your savings. 

This means that you can use the normal amount of cash you’d be investing annually and save about 15-20% instead of investing it all. If you don’t need to be as conservative, you’d be fine with saving only about 5-10% of your regular investment money during this period of inflation.

This frees you up to keep between 80-95% in stocks over the next year. 

Most of all: Be patient. Stay calm. And, don’t forget to download the Wealth Stack app so that you can learn how to invest as a beginner. We’ll teach you all about the right investment strategies and how to put them to use.