Inflation and How it Affects the Economy

If your money doesn’t buy as much as it used to in the past, that’s an inflation effect. Inflation is the reduction in the buying power or value of money, and it often reflects the hike in prices of services and products. It doesn’t have to do with just the increase in prices of one commodity relative to another; it’s a general increase. The prices of goods and services keep increasing as each day passes—this is one of the effects of inflation.

What is Deflation?

Deflation (opposite of inflation) refers to a situation where the buying power of money increases, and there’s a reduction in the prices of services and goods.

Most central banks place their inflation rate at 2%. However, economists urge people to target higher inflation rates because of its advantages as well as disadvantages.

However, inflation doesn’t just occur; it’s a result of several factors, some of which include:

• Demand-pull Inflation

This type of inflation occurs in a situation where the demand for a commodity outweighs its supply. In this case, people are willing to buy, and producers are willing to supply, but due to one reason or another, the goods available for supply are not up to the demand, leading to a hike in price. Demand-pull inflation can be as a result of so much money and increased spending or expectation of inflation.

• Cost-Push Inflation

This type of inflation occurs in situations where the cost of supply of services and goods rises, and the level of supply falls. In this case, the demand for these goods and services remains the same while the supply changes. This could be a result of natural disasters.

The similarity between these two is the general increase in the price of services and goods.

Other causes include:

• Increase in Demand

When the demand or want for a particular commodity becomes greater than its availability, inflation will arise. For instance, when products are scarce due to production issues, they would no longer be bought at their regular prices but higher prices.

• Increase in Population

When the population of a country or an area increases, demand for products increases. These products would become scarce, and the available ones become more expensive.

• Hoarding

Hoarders are people who keep or hide commodities and make them scarce. It causes excess demand and leads to inflation because when such commodities become scarce, the hoarders would bring out the hoarded goods and sell them at higher prices.

• Excess Circulation of Money

You might be wondering how excess circulation of money causes inflation. Well, excess circulation of money makes it lose its purchasing power because when individuals have more money, their spending increases, and so does the demand for commodities.

• Cost of Raw Materials

An increase in the cost of raw materials always affects the price of finished goods and services in one way or another. For example, when crude oil price increases, it affects the price of fuel and other products made from crude oil.

• Trade Unions

As trade unions increase their workers’ wages, there is a change in the prices of goods, which can lead to inflation.

• Disadvantages of Inflation

There are many adverse effects inflation has on both the economy as well as individuals. From uncertainty to the high cost of living and more, high inflation doesn’t sound nice at all. The rise in prices of commodities can become quite unbearable and even dangerous to the economy and individuals in many ways, some of which include:

• Hard to Invest

Inflation makes it hard for individuals as well as corporate bodies to invest. No sensible person would like to invest in any venture when they are not certain about its profitability. With prices increasing every day, no one is sure that investing in commodities can bring them as much profit as they expect.

• Decreases International Competitiveness

Inflation can affect the rate at which a country imports and exports goods. International competitiveness is a measure of the cost of a country’s exports. A country with high inflation rates makes exports less competitive—exports fall, and there is a deterioration of accounts.

• A Decrease in the Value of Savings

Savings will become less valuable when there’s inflation. This problem is one of the most obvious effects of inflation. The sum of $20,000 kept in a piggy bank cannot be used to buy the same commodities as it used to in the past. However, the fact remains that no money has been lost, but the net worth is lower than it would’ve been.

• Uncertainty

With high inflation, there is bound to be uncertainty. Most individuals don’t know what to spend their money on, and even most corporate organizations would not like to invest. This is because no one knows how much profit they would make from such commodities in the long run. If the prices of commodities reduce, every other firm will sell theirs at lower prices, and as such, it would be a loss on the side of such investors.

• High Cost of Living

With inflation—an increase in the price of goods or services, there is always bound to be an increase in individuals’ cost of living. An increase in the cost of living will most probably make several families poorer than they initially were.

• Advantages of Inflation

Although known mostly for its negative effects, inflation has some advantages that can be seen as the light at the end of the tunnel. High inflation tends to come with many negative effects, but moderate inflation comes with numerous advantages.

Some of these advantages of inflation include:

• Economic Growth

Inflation encourages individuals as well as corporate bodies to make purchases. It makes people want to rush out and get those products that seem to be scarce before they are completely out of the market. Inflation also nudges people to buy goods sooner because no one knows how much the prices of such goods would increase subsequently, and when more people buy, it boosts economic growth.

• Borrowers Pay Less

Borrowers are usually so lucky during inflation. This is because, with the value of money lower than what it used to be, borrowers would be paying less than what they borrowed initially. Therefore, it is safe to say that inflation favors debtors more than deflation because during deflation, the value of debt increases.

• Tax Revenue Increases

Inflation makes the government increase tax revenue. This way, it is easier to pay off debts, as well as increase its income and boost the economy.

• Increase in Wages

Inflation creates an increase in wages. With inflation, more commodities are sold out at increased prices, and as such, firms can increase their workers’ pay to a certain extent. It can also lead to the employment of more labor because of the increase in demand and production of commodities.

• Inflation Prevents Deflation

Inflation and deflation cannot occur simultaneously—when there is deflation (a fall in the prices of goods and services), the economy is at risk. This is because most individuals would prefer saving or keeping their money to purchase those goods when they become extremely cheaper in the future. This brings everything to a standstill, with customers waiting for a fall in price and sellers looking for a means to sell such goods in order not to lose.

• Control of Inflation

Inflation sometimes poses a threat to the economy, but it can also be controlled by some absolutely easy measures, just like every other problem. They include:

• Increase in Tax

One way to reduce inflation is to increase tax. This tends to reduce import duties as well as deal with inflation.

• Reduce in Circulation of Money

When there’s an excess supply and circulation of money, people tend to buy more, leading to inflation of the economy. However, when there is a slight reduction in the circulation of currency, inflation can be controlled.

• Increase in Production

When there is a decrease in the production and availability of goods, inflation occurs. However, there would no longer be excess demand when production increases and inflation is kept moderate. This could be by employing more labor or importing needed raw materials.

• Controlling Prices

Price control is another interesting and easy way to check inflation. When there is a maximum price regulation of a commodity, it prevents a hike in prices no matter how scarce such a commodity is.

With both the advantages and disadvantages of inflation, it is best to keep track of expenses and the rising cost of goods and services. An easy method to do this is the use of an inflation calculator.

When an individual’s income remains stagnant and inflation increases, the effect on the economy would be felt more; hence, inflation affects individuals with a fixed income more. When an individual’s investments don’t provide equal or greater returns than the inflation rate, such a person would also be affected.

After weighing the pros and cons, it is safe to say that moderate inflation undoubtedly serves as a balance in the economy.