What is Inflation, and Why Does it Matter?

Thu Oct 13 2022

Introduction

Inflation is one of the most important economic concepts out there. It's also been hitting headlines lately, as you will no doubt have noticed. But what is it, and why does it matter? In this blog post, we will explain how inflation works and how it can affect your everyday life. We will also discuss how the government tries to control inflation, and what you can do to protect yourself from its effects.

What is inflation and how does it work

Inflation is a measure of how much prices for goods and services have increased over time. The main cause of inflation is too much money chasing too few goods and services. The inflation rate is the actual % increase or decrease in prices over a given period. When there is more money in the economy than there are goods and services to buy, prices go up. This causes inflation. There are two main types of inflation:

  1. Demand-pull inflation: This happens when there is too much money in the economy and people start bidding up prices for goods and services. This can be caused by things like a growing economy, inflationary expectations, low interest rates, tax cuts and innovation.
  2. Cost-push inflation: This happens when the cost of production goes up, and businesses pass these higher costs on to consumers in the form of higher prices. This can be caused by things like increases in the price of raw materials, scarcity of resources, low unemployment rates and declining productivity.

It can also spiral once started, which is more of an implicit force than the other two. In a wage-price spiral, workers are expecting wages to rise in order to match the increase in living costs. Higher wages then make companies increase the price of their goods and services, causing workers to demand higher wages and setting off a perpetual cycle.

Inflation can be a good thing or a bad thing, depending on how it is affecting the economy. If inflation is too high, it can cause economic problems. But if inflation is just right, it can help the economy grow. For example, inflation erodes our national debt, which means that in real terms we owe less money to our creditors.

How does the government try to control inflation? There are two main tools to control inflation: interest rates and money supply.

  1. Interest rates: The government can raise or lower interest rates to help control inflation. If the government raises interest rates, it becomes more expensive for people and businesses to borrow money, which slows down economic growth. This can help reduce inflation. So interest rates are generally inversely correlated with inflation rates.
  2. Money supply: The government can also control how much money is in the economy by printing more money or taking it out of circulation. If the government prints more money, this can cause inflation to go up. But if the government takes money out of circulation, this can help reduce inflation.

How does inflation affect your everyday life

Inflation can have a number of effects on your everyday life. The most direct effect is that it makes the things you buy more expensive. This can be a problem if your income doesn’t go up at the same time as prices. Inflation can also make it harder to save money, because the value of your savings will go down over time. 50 years ago, a cup of coffee would have cost less than £0.40, compared to an average of £2.70 today.

Inflation also affects exchange rates: more of one currency in circulation means that it loses relative value in relation to other currencies. Imports then become more expensive as more domestic currency is required to purchase them.

More broadly, it reduces the value of savings, fixed rate pensions and fixed rate contracts. Borrowers with variable rate loans also often see their interest rates increase as the government raises the base rate to make their currency more desirable.

What can you do to protect yourself from inflation

There are a few things you can do to protect yourself from inflation. One is to invest in assets that either outpace inflation, as equities tend to, or those that tend to go up in value when inflation is high, such as real estate or gold. Another is to make sure that your debt payments are fixed, so that you don’t have to worry about them going up over time.

Ben Waterman

Written by Ben Waterman

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