How Inflation occurs and how it eats up savings account

How Inflation occurs and how it eats up savings account

Inflation as defined by the oxford dictionary is a general increase in prices and a fall in purchasing value of money. Inflation is actually the difference between aggregate demand and aggregate supply of goods and services. When aggregate demand exceeds the supply of goods at current prices, there is a rise in the price level.

Doesn’t sound complicated right?

We were able to sum it up in a single sentence but inflation is not a simple subject but it remains a pretty contentious topic in the world of economics even the definition I just read is can be found out in a simple Google search.

Most of us have a basic understanding of what inflation is and indeed why it’s bad for our savings accounts but how it’s measured and how it affects our economy remains a widely debated subjects. 

Inflation has been a key driver behind the collapse of many modern nations over history. 

Zimbabwe, the country issued a trillion-dollar bill just to keep its currency portable, and yet most modern economies target a positive inflation rate believing it to support economic activity. 

So how does inflation work? 

Why cant people seem to agree on inflation and what to about it? 

You may have come across videos or articles on inflation that describe how badly it affects our savings. 

 Every year prices tend to rise which means the money you have sitting around is worthless and less while most developed economies target an inflation rate of around 2%. This even still can add up it just takes 35 years at this rate for prices to double it’s easy to see why inflation is such a big subject for investors. 

Given that stands as a sort of hurdle rate that needed to surpass to grow our wealth in real terms and the phenomena has drawn a lot of disdain over the years.

So it might be perplexing that the government would ever want inflation and indeed the fact that the governments continue to target a positive rate, has caused much frustration of the markets, it’s one of the reasons we have seen many people rally behind digital assets like Bitcoin where they have limited supply hardwired into their code.

But there’s arguably a justification for these actions and today we will counter both sides of the argument. Not to try to convince you of one way to another but just to lay out the debate as it exists. 

Before we get into all of that, let’s start from the beginning. 

If you remember your supply and demand curve from your first-year economics course ( if you ever took one) you will know that a shift in these curves causes a change to the price and quantity of goods sold in an economy. 

Increases in prices occur when either demand rises or supply falls.

In other words, there are two broad causes of inflation. 

What are the causes of inflation?

COST-PUSH AND DEMAND PULL

COST PUSH deals on the supply side of things and it commonly occurs because of a shortage of some key input, either because of a supply chain disruption or inventory mismanagement.

This can cause producers of that goods to increase the price for that thing which will force companies that use that product to do the same and eventually passing it on the cost increase to consumers.

A great example of something that can cause this sort of inflation is rising oil prices despite our transition away from fossil fuels. 

Oil remains a pretty key part of the economy given its role as a fuel for transporting goods and as a raw material for things like plastics. 

And when there’s a supply chain disruption says an attack on the oil pipeline can cause prices of many goods, not just gasoline to rise. 

Another input shortage that can cause cost-push inflation is LABOR

Some factors can cause a labour shortage from a mismatch of skills and an aging population but regardless of the cause companies may increase wages to attract talent now while most of us would probably enjoy a pay raise at a large scale it too can cause inflation. 

Since companies will likely pass the cost of their more expensive employees, again on to the consumers. Something that over time can initial real impact that wage increase has on that employee’s wealth. 

DEMAND PULL

Demand-pull inflation happens on the demand side of things. 

Here consumers are buying goods at a rate at which suppliers can’t keep up causing them to charge higher prices for their products this is usually what economists are referring to when they say an economy is overheating and it can occur because the general population is experiencing prosperity it is heavily influenced by both government and central bank actions. 

A fiscal stimulus such as tax and taking on debt to expand social benefits act as a tonic to demand as households find themselves with extra cash.

There are also impacts of monetary policy. Central banks can influence the economy by expanding the money supply and credit.

Things they often achieve by lowering interest rates and through quantitative easing where the central bank creates money and uses it to purchase bonds to support debt markets.

These actions can boost demand short term. Cheaper debts mean more people will likely take out loans to buy goods and businesses flush with cash should in theory pursue business generating activities. In the longer term the higher the demand can again pull inflation higher. 

In Canada for example, real estate prices have skyrocketed thanks in part to a prolonged period of low-interest rates which made more mortgages very cheap for consumers.

Printing money to buy assets is often looked upon as one of the key factors of inflation as it directly lowers the value of a currency which inherently will cause prices to rise. 

If the money supply increases each unit of the currency becomes less valuable it’s less rare, meaning that once prices adjust to reflect this new value a single unit won’t be able to buy as many goods as before.

Many countries have driven their economies into the ground by printing too much cash although it is that this QE is intended to be a temporary measure. 

The impact on money supply should eventually be reversed once the central banks unwind their programs and take the money back out of the system. The problem is that this has proven difficult to do than said.

Us government was still unwinding its per from the 2008 financial crisis when it restarted the program to help with the covid 19. 

So now know you know that inflation comes from many sources and while supply shocks are rarely helpful. 

Some causes of inflation are arguably positive. I am not saying that rising prices in and of themselves are good but inflation may simply be an outcome of strong economic activity and rising consumer wealth which is both positives. 

It’s, for this reason, is that many countries target positive inflation. Since it’s believed to be a sign of strong economic activity. 

As William Simon, Nixon’s secretary of treasury put it 

“I continue to believe that the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it. “

At the same time, inflation does come at a cost, outside of the negative impact it has on your savings. 

Inflation distorts an economy’s allocation of resources after all it’s a messy phenomenon that impacts different areas differently. 

So while grocery prices might rise 5%, wages may only increase only 2%.

Changing prices also bring complications and costs to businesses and of course, there’s the very real risk that inflation evolves into something more sinister.

How should countries deal with inflation?

Well, that’s a billion-dollar question, and it depends on who you ask, many countries follow a Keynesian approach referring to the school of thought that advocates for governments and central banks to intervene to stabilize economies and keep inflation under control. 

 The thinking is that the economy naturally experiences booms and busts that impact price levels and that by providing stimulus during down terms and austerity during good times volatility can be reduced and inflation can be kept in check. 

But not everyone agrees with this approach, Monetarists another school of economic thought believe inflation is primarily caused by the central banks’ influence on the money supply. 

Going so far as to contest the commonly accepted definition of inflation arguing that it is instead the increase in the quantity of money in credit that thereafter causes prices to rise as such they argue that central bank policies should be kept stable to avoid both excessive inflation and deflation (the falling of prices).

There are other schools of thought meanwhile that go a step further and argue that economies have a tendency towards deflation and that inflation spoils economic progress. 

In truth, there are issues and limitations with all these philosophies. 

Regarding intervention, it is very difficult to gauge the timing and degree of impact that simulative measures will have on an economy.  Governments may distort things further by adding and then taking away supportive policies.

On top of this while increasing spending during downturns has been an easy step to follow politicians aren’t good at reducing their spending after the fact which can increase the risk of hyperinflation.

Furthermore, while Keynesian Economists believe simulative measures can boost economic activity before prices adjust. Businesses and consumers can come to expect inflation and act accordingly. 

Raising prices proactively and nullifying the impact, meanwhile don’t do well to accommodate for external shocks for outside the realm of monetary policy while monetarists and Austrian subscribers believe economies do well to destabilize themselves .

Importantly there’s also the fact that money supply doesn’t have a direct correlation to price despite what some may suggest. In Japan, for example, we saw a money supply rise through the 2000s and yet prices fell during this period this was because the rate at which money changed hands known as the Velocity of money declined over the period.

Partially thanks to the declining population so while some argue that money supply is the only thing that caused prices to rise that’s not the case but the disagreements don’t stop there. 

To track inflation

The types of assets included in measuring inflation are widely debated should inflating include durable goods such as real estate.

What about volatile items like energy, this is in addition to criticisms of the commonly used inflation metrics such as the CONSUMER PRICE INDEX which tracks the change of a fixed basket of goods over time.

While this approach does provide a gauge of the price level it doesn’t track the consumer behavior or even the goods included in the basket maybe people buy less peanut butter if it comes more expensive or perhaps peanut butter is 20% nuttier than it was just a few years ago.

These things that wouldn’t be caught in the standard measure of inflation with people not agreeing on what inflation is, what it does, and how to deal with it or heck how to track it.

You can see why it makes for a pretty complex area of economics when you add in the fact that some people don’t even trust the government and central bank authorities to publish accurate figures given that they stand the benefit from keeping expected inflation low.

It’s easy to understand why the discussion of this topic gets heated pretty quickly and the tricky thing is we may never come to a consensus on the matter.

Some periods support some theories while others contradict them some countries especially us face different circumstances around inflation given the global dominance of their currency compared to smaller countries it all makes for a pretty difficult code to decipher fortunately there are few truths most people would agree on. 

Lastly,

  1. Many factors impact inflation, this makes controlling inflation very difficult. 
  2. Aggressive strategies to utilize inflation to boost output can easily backfire as it’s done many times in the past

It’s important to build prudent saving strategies throughout your lifetime it’s likewise important to invest the money you tuck away. While a mattress seems like the smart spot to put your earnings. 

  1.  The inflation bug nibbles your money no matter where you hide it. 

So hopefully you have a better understanding of the topic. It is something to take seriously either by governments or an average person who wants to save his retirements savings. 

Thank you.



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