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So, What’s Up With Inflation, Exactly?

One of the many buzzwords that have been thrown around throughout the pandemic, especially in recent months, is inflation. Long thought to be solely in the purview of economists and central banks, inflation has come of the gate swinging in response to governments’ measures to stimulate the economy in reponse to impacts of COVID-19.

But what is inflation exactly? And why should you care?

(Quick disclaimer: I am not an economist, nor an expert. This article was written using my knowledge from my education in business, which included some economics, and my own reading and research. Please do not simply take me as an authority on this subject and supplement this article with your own research.)

Generally speaking, inflation is the measure of an increase in prices over time. It’s usually used as a broad descriptor of the overall cost of living, and can be calculated for individual items/sector (e.g. meat, dairy, automobiles) or for the overall economy as a ‘basket of goods’ (which is economist-speak for all the goods and services the average person purchases).

Put another way, inflation also measures the decrease in purchasing power of a currency in relation to higher prices. Translation — you need more money to buy the same thing, because each unit of currency is worth less in real terms.

Sidebar: You will often notice the words ‘real’ and ‘nominal’ used when discussing economic subjects. What do these terms mean? Imagine you get a 3% raise at work. Your nominal raise is 3%. However, if inflation is 5%, your real raise is actually -2%, as although you now make 3% more, inflation has reduced your purchasing power by 5%.

Why Does Inflation Happen?

As previously mentioned, inflation is the rate of increase in prices for a basket of goods and services. The above graph is the most basic graph in economics, representing supply (S) and demand (D), along with Price on the y-axis and Quantity on the x-axis. The black dot at the intersection of the D and S lines represents equilibrium — the price and quantity produced where demand meets supply (i.e. if the equilibrium price was $100 and quantity was 100, this means that for that price and quantity, there is no excess demand or supply — demand perfectly matches supply).

Inflation happens when one of the curves shifts such that the new equilibrium point sits at a higher price point. Imagine for example the supply curve shifts to the left. This would result in a lower quantity in the marketplace, as well as higher prices. That rise in prices is inflation.

In the supply curve example, what might cause this? To use a very simplified explanation, imagine there is a town with 100 houses. One day, 25 of those houses burn down in an accidental fire. Now, the supply of houses has decreased (shift in the demand curve) as there are less houses in that town. The demand hasn’t changed however, and so there will be more competition for the remaining houses as the same number of people are competing with the others for fewer of that resource.

That’s just one possible explanation for inflation. The following infographic illustrates the three main drivers of inflation. We have also seen in recent years the rise of a fourth driver in the form of quantitative easing (QE), which is when governments print very large amounts of money to inject into the economy in order to stimulate demand (also known as: money printer go brrrrr).

Melissa Ling {Copyright} Investopedia, 2019

Is Inflation a Good or a Bad Thing?

That depends on your situation and your point of view. It is generally accepted that a small amount of inflation is healthy for economies, where prices rise but so too does production, demand, and wages. That is why central banks often try to maintain inflation at around 2% or so. Now, your individual opinion may differ significantly. If you are an asset owner (stocks, real estate, etc.) you will generally be in favour of inflation, as it means the price of the assets you hold increases, thereby increasing your wealth. If you do not own assets, it is likely that you will hold a less favourable view of inflation, as price increases across the board mean that you pay more for everyday items, such as food, and do not benefit from the boost in asset prices.

Too much inflation can certainly be a detriment to the health of an economy. Higher rates of inflation lead to rapid price increases, which affect lower and middle class individuals to a much higher extent. Wage growth has been fairly stagnant in the developed world over the past few decades, and so many people see their purchasing power eroded while largely not seeing a balancing force in the form of higher wages. This creates a vicious cycle where higher prices with the same pay forces people to put more of their income towards the essentials, leaving less with which to purchase wealth-building assets, which have themselves increased in price, further compounding the problem.

You also have examples of extreme inflation, also known as hyperinflation. If you’ve ever heard of what transpired in 1920s Germany (Weimar Republic), or Zimbabwe in the 2000s, this is hyperinflation. Hyperinflation is characterized by a month or more of inflation being 50% or more. It usually occurs in periods of turmoil or instability — in the case of Zimbabwe, we saw banknotes in the hundreds of billions and even trillions printed. Imagine your currency being worth so little that you go from paying $10 for a sandwich to paying $100,000,000,000 for that same sandwich.

Does Inflation Always Occur?

Inflation is not always positive. Prices can decrease when the inflation rate falls below 0%. This is known as deflation. On a surface level, deflation can be viewed by many as a positive thing because prices decrease and purchasing power increases, and there are certainly some positive drivers of deflation, such as an increase in productivity and/or an abundance of resources (imagine a technology shift such as the printing press, or the discovery of an enormous new lithium mine). Other drivers of deflation can be a decrease in the money/credit supply, or a decrease in aggregate (overall) demand. It can be the sign of a healthy economy, but can also signal a weak economy, in particular when said economy is laden with debt and dependant on continuous expansion of credit availability to fuel speculative investment (i.e. asset prices rising). If the supply of credit were to diminish, it could trigger a cycle of asset liquidation, cratering prices and causing what is known as debt deflation.

What Can I Do To Fight Inflation?

In times such as these, where inflation is running higher than targeted thanks to government intervention and QE, it is perfectly understandable that many people are feeling the squeeze more than ever, especially when combined with potential job losses due to the pandemic, and other factors. Here are the two best things that you can look to implement to help minimize the impacts of high inflation:

  • Increase your income: Easier said than done, perhaps, but one of the most effective ways of combatting inflation is to increase your income. This could be by switching jobs (proven to be more effective at raising your salary than staying with the same company), negotiating with your current employer, starting or developing side hustles, and investing in income producing assets.
  • See where you can reduce expenses: Going back to my article about minimalism, having less things that you need to spend money on, and reducing your overall expenses will leave you with more money that will help cushion against inflation. Another idea could be to adopt a diet model with less meat/diary/other items that have seen large increases, which can help with the grocery bill (one of the most expensive bills these days).

Conclusion

To conclude, inflation is a natural force in our economies, and we as individuals cannot change it with our individual actions. What we can do is educate ourselves on what it is, why it happens, and plan/take action for when it happens and it starts to affect us. In times of stress and economic difficulty, knowledge and a plan are the best tools at your disposal, and there is an entire world of free knowledge out there on the Internet with which to arm yourselves (take care to make that it is from a reputable source). The world of economics is no longer reserved for the central bankers and think-tanks — we are all participants, we are all affected, and it is up to us to use it to our advantage.

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Me? I’m your friendly Internet stranger who writes about his passions — personal finance, personal development, art, and wine.

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Alex Reid

Alex Reid

Me? I’m your friendly Internet stranger who writes about his passions — personal finance, personal development, art, and wine.

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