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How Does Inflation Work? Understand the ins and outs of inflation

Understanding inflation is critical to any financial activity, whether you’re buying goods and services, investing your savings, or trading assets. It affects every aspect of any economy, dictating annual market fluctuations and driving economic growth worldwide.

The foreign exchange market, for example, relies on inflation for stability, growth, and speculation control. But why is inflation so important? What makes it a necessary component of a successful economy?

In order to gain a thorough understanding of inflation and its effects, it’s important to study the definition of inflation, why inflation is beneficial for economic stability, and how a lack of it can be a threat to even the most resilient economies. With that in mind, read on to find out all there is to know about inflation.

Inflation defined

By definition, inflation is the rise in the costs of goods and services and the subsequent reduction in the value of any given currency. Essentially, this increase in costs drives economic growth, urging consumers to purchase products before prices increase.

Without inflation, consumers would hold on to their earnings, waiting for price reductions or increased production, which would stall the economy and cause it to spiral. This is known as deflation, and it’s one of the many types of inflation a market can experience.

High inflation, also known as hyperinflation, can also cause a currency to lose value. Moderated inflation maintains a healthy economy, but extreme inflation in either direction can cripple your purchasing power and stifle economic growth. Evidently, the key to a healthy inflation rate is balance. 

A stable rate of inflation can only be achieved through a combination of competent governance and effective monetary policy. These responsibilities are typically handled by the central bank of any given country.

Control of inflation

The Federal Reserve is responsible for the regulation of inflation in the US. Considering how crucial the Federal Reserve System is to the stability of the US economy, it makes perfect sense that it should have at least some degree of control over the demand and supply of currency.

Aside from deciding monetary policy, the Federal Reserve is tasked with regulating all banks nationwide, as well as providing financial services to various institutions of both foreign and domestic origin. 

The annual rate of US inflation is affected by several factors that are outside of the Federal Reserve’s control. These factors largely fall under three categories of analysis: the Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCE), and the Producer Price Index (PPI).

Consumer Price Index (CPI)

The CPI takes average consumer spending and compares it to the average prices of goods and services. It measures the overall change in spending for any given market, provides consumers with an accurate picture of future markets, and is currently the most widely used measure of inflation.

Personal Consumption Expenditures Price Index (PCE)

Compared to the CPI, the PCE uses a much larger group of products for supply and demand analysis. It takes supplier revenue and all consumption into account, which is useful as a comparative tool when weighed against the CPI.

Producer Price Index (PPI)

Compiled from indexes that measure producer expenditure, the PPI provides a broad overview of the status of the US economy. This index is predominantly based on private contracts, making it a primary source of reference for manufacturers and service suppliers.

Why is inflation necessary?

If demand for goods and services increases but production remains the same, prices will keep going up. Similarly, if production is limited in any way, the value of products and trade skills rises in consequence. By maintaining oversight of this precarious dynamic, the Federal Reserve ensures that the US economy can thrive over time.

Nobody likes rising prices, but a small percentage of annual inflation provides a stable foundation for growth. In the case of an economic downturn, it also gives the Federal Reserve the ability to ‘jump-start’ the economy; lowering interest rates to encourage spending and drive consumption.

The Federal Reserve Act has three primary objectives that dictate US monetary policy: maximizing employment, regulating interest rates, and maintaining price stabilization. All three objectives are required for economic growth, but none of them are achievable as long-term goals without stable inflation.

How to account for inflation

It can be frustrating to experience the rise in the costs of goods and services. Inflation doesn’t affect all people equally, and some of us feel the effects of it more than others. Wage and salary adjustments that account for inflation aren’t always possible, so it’s definitely worth your time to focus on investments that counter the effects of inflation.

Despite the fact that it erodes your money’s value over time, healthy inflation can be offset by several profit-based strategies, such as stock trading and bond investments. Treasury Inflation-Protected Securities (TIPS) can be particularly useful against inflation, as their bond value changes in accordance with fluctuations in the CPI.

Contrary to popular belief, investing in gold and other precious metals isn’t always a safe bet. Depending on a variety of factors, the prices for these commodities can vary greatly. Gold has decreased in value significantly at least twice in the last ten years, for example.

Silver and platinum are nowhere near as volatile as gold is. However, all precious metals are impacted by supply and demand, monetary policy changes, and even foreign exchange. You also have to store these commodities somewhere, which is an issue all on its own.

Essentially, you’re investing through speculation with a high long-term capital gains tax rate. For lower tax rates and worthwhile investment returns, stick to stocks and bonds. That being said, a diverse portfolio of investments will serve you best, as it provides you with multiple avenues of income.

Investments and side hustles won’t prevent you from feeling the effects of inflation entirely, but they will dampen the blow somewhat. At the end of the day, the only method of overcoming cost increases is to make more money. It’s as simple as that!


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