Inflation - The Basics
What is inflation?
Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.
Example: Last year a gallon of milk was $2. Now a gallon of milk is $3. It is the same gallon of milk. Same plastic, Same Cow, Same Farm, Same Store, Same Everything… but the price is different. Why? Because the value of the money has changed. The milk is still worth the same. The money is worth less. This is inflation. Over time this is a more pronounced thing. You probably have heard your parents or grandparents talk a bout how cheap things were when they were younger. A soda was 1 penny or something like that. Coca-Cola is still Coca-Cola… the difference is the money.
Why is it important to understand inflation?
Inflation can significantly affect an individual's financial planning and decision making. For example, if you know that inflation is expected to be high, you may decide to invest in assets that tend to perform well during times of high inflation, such as stocks or real estate. On the other hand, if you expect inflation to be low, you may choose to invest in assets that offer a higher fixed rate of return, such as bonds.
Inflation can also impact the value of money itself. If prices are rising faster than the rate at which money is being saved, then the purchasing power of that money is decreasing. This is why it is important to keep track of the rate of inflation and factor it into financial planning. Your money is like a bucket of water… slowly evaporating over time. If you aren’t finding ways to get investments that beat inflation you are losing money.
Example:
Person A is very risk adverse. He cashes his check every week and takes all the money as cash. He then sticks it under his mattress.
Person B is not a weirdo, and deposits his check in the bank - where the bank offers him 1% interest on a saving account.
Person C is a weirdo, he collects bugs and organizes his socks based on the thickness. He cashes out his check and invests the money in stocks — like an index fund that gets around 4% growth most years.
If inflation is 2% both person A and B are both losing money. Their money is worth less than it was the year before. They have less functional buying power (they can buy less milk). Person C, even though he is a weirdo, has managed to actually net 2% positive (4% gain - 2% inflation loss = 2% gain). He can now buy more bug collecting equipment than he could the year before.
Types of inflation:
Demand-pull inflation: This type of inflation occurs when there is an increase in demand for goods and services that outpaces the available supply. This can lead to higher prices as businesses try to meet the increased demand.
Cost-push inflation: This type of inflation occurs when there is an increase in the cost of production, such as an increase in the cost of raw materials or labor. This can lead to businesses passing on the higher costs to consumers in the form of higher prices.
Want More ? Article on Demand Pull Inflation
Want More ? Article on Supple Push Inflation
Measuring inflation:
The most commonly used measure of inflation is the Consumer Price Index (CPI), which is a measure of the average price change for a basket of goods and services consumed by households.
Another measure of inflation is the Producer Price Index (PPI), which measures the average price change for goods and services produced by businesses.
Want More ? Article on Measuring Inflation
Managing inflation:
Central banks, such as the Federal Reserve in the United States, use a variety of tools to manage and control inflation. These tools include adjusting interest rates, setting targets for inflation, and implementing monetary policies. People always freak out they are doing it wrong.
Conclusion:
Inflation is a key economic concept that can have a significant impact on an individual's financial planning and decision making. It is important to understand the different types of inflation and how they can be measured and managed.
