Explaining Inflation – How It Works and Why You Should Care

Inflation is a complex economic concept that affects every aspect of our lives, from the cost of groceries to the price of a new car.

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High inflation and low inflation are both concepts that are often discussed in the news. We might hear about how much the cost of living is rising, or about which products are getting more expensive. But what does that actually mean? High inflation means the prices for goods and services are increasing at a rapid rate. Low inflation implies that there is a slow rate of increase in the cost of living.

High inflation rates typically have adverse impacts on an economy as they diminish savings, result in hoarding, and prompt lenders to opt for riskier assets that offer higher returns, as they are disinclined to lend money at lower interest rates. This article will explore what causes inflation and why it’s important to understand if you want to build a stable financial future.

What is inflation?

Inflation occurs when the prices of goods and services are rising. This essentially means that the purchasing power of your money is decreasing — which is why it’s important to understand how inflation works. Inflation is measured as the percentage rate of change in the price level of goods and services in an economy.

This means that if prices are increasing, they are rising. And vice versa. If 100 items are priced at $1, then the average price of those $1 items is $100. If the price of those items increases to $2, then the average price of $1 item is now $200. The average price has risen from $100 to $200, so there has been an inflation of $100.

Why does inflation happen?

Inflation can occur for a variety of reasons. Some of these include:

  • Increased demand for goods and services

  • When there are more people buying goods and services, companies produce more products to meet that demand. To do so, they need to acquire more raw materials, which can drive up the price of those materials. Higher prices for materials can then lead to the production of more expensive finished products.

  • Decrease in the supply of goods and services – The price of a good or service can also go up if the supply of it drops. Inflation can also occur when natural disasters, war, or other major disruptions reduce the availability of a necessary product.

  • Expansionary fiscal policy – When the government spends more than it collects in taxes, it adds to its budget deficit. This can cause interest rates to rise. Higher interest rates make it more expensive for people to buy homes and cars or take out loans. This can lead them to pay more for goods and services, which can cause prices to rise.

How does inflation affect the economy?

The rate of inflation is an important factor in measuring the health of an economy. When inflation is high, people's savings and wages tend to lose their value, making it challenging to plan and finance significant expenses like mortgage payments, retirement, or college education expenses.

When the prices of goods and services are rising, it’s often hard to know how much they are increasing. This uncertainty can cause people to delay major purchases and investments until they have a better understanding of how the cost of living is changing.

Since loans are generally paid back using money, inflation can make it harder for people to repay debt. Time-based loans like mortgages, student loans, and auto loans are usually adjusted to account for inflation. This means that the amount you owe will increase as the rate of inflation rises.

The costs of high inflation

High inflation can have a significant impact on your finances, creating obstacles that make it harder to save money. It can also diminish the incentive to spend and prompt more risky investments in the stock market, ultimately leading to financial strain.

Saving money – When the amount you have to spend on living expenses is increasing, it’s harder to save for large purchases. If the cost of living is rising quickly, it’s important to find ways to cut back on expenses so that you can save for the things you want or need. You can start by tracking your spending and finding areas where you can save money.

Less incentive to invest – If inflation is high, it can make it more profitable to lend money rather than save it. This means that interest rates on loans may increase, making it harder for people to invest and grow their savings.

Risky investments – If inflation is high, stocks might not be as profitable as they usually are. This is because companies usually increase their prices to account for rising inflation. If the price of a company’s products is rising, they might experience less demand and their profits might decrease. This can make stocks less profitable and make it harder for investors to get a return on their money.

The Bottom Line

When the rate of inflation in an economy is high, it makes it difficult to plan for the future. It can be challenging to save money, invest, and make smart financial decisions when you don’t know how much something is going to cost in the future. If you want to build a stable financial future, it’s important to understand what inflation is and how it works.