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Finance From A to Z: Week 9 (I)

Finance From A to Z: Week 9 (I)

From the grandest aspects to the most minute contributors, inflation has a significant impact on the economy, and subsequently, the financial world. Hence, in this week’s issue, we will dive into the details of inflation!

I is for Inflation:

What exactly is Inflation?

Simply put, economists generally refer to inflation as a general rise in the price level of goods and services within an economy over a period of time. Generally, inflation is measured as the percentage change in a price index compared to the previous year. 

How does inflation affect us? What are the costs and benefits?

In very broad terms, inflation impacts every aspect of the economy. For example, inflation impacts the people and businesses that contribute to the economy, the investments we make, and the decisions and policies that the government implements.

There are several significant implications of this phenomenon in the real world. For example, inflation decreases your ability to buy goods and services, otherwise known as your purchasing power. Moreover, inflation reduces the value of money, which is why you generally want to have yearly increases in salary to match the inflation rate because otherwise, you’ll actually be losing money to inflation instead.

This loss of purchasing power is damaging to everyone's standard of living. When inflation is high, consumers, businesses and investors will become uncertain about their costs each and every day. This uncertainty generally manifests itself in a manner that causes investors to pull out their investments, knocking the financial world upside down sequentially.

In a more nuanced view, however, we can also see the effects inflation may have on a myriad of costs that would otherwise not be inflicted upon businesses and consumers in a different situation. Notably, these include menu costs — the costs to businesses resulting from regularly changing their prices, shoe-leather costs — the costs to businesses and consumers because of the extra trips to the bank, and of course, the inflation tax, wherein money loses its value when inflation is high. Similarly, inflation also breeds tax distortion wherein nominal interest rates cause people to be overtaxed. Finally, unexpected inflation is harmful because people will waste money attempting to forecast inflation and may avoid borrowing or lending at all. Unexpected inflation can therefore reduce activity in an economy, given that relative prices become distorted and society does not know where to allocate resources efficiently.

Unemployment and Inflation

Historically, inflation has held an inverse relationship with unemployment. In other words, unemployment decreases as inflation increases. In terms of macroeconomics, this can be explained by the increased spending power of employed consumers, which leads to an overall decrease in demand. Note that the unemployment rate and the inflation rate are intricately linked to the recession and expansion cycles of an economy. An expanding economy is usually bustling with activity, low unemployment rates and inflation. On the other hand, economies in a recession generally deal with lower economic activity, higher unemployment rates, and lower inflation.

In rare instances, however, inflation can coexist with symptoms of an economy in recession. This is usually the worst-case scenario, and it’s termed stagflation, a portmanteau of the words stagnation and inflation. In essence, stagflation describes an economy with high unemployment, little to no growth, and high levels of inflation. It occurs, hypothetically, when the supply side of the economy is constrained whilst the amount of money in the economy is growing.

This results in people being unable to purchase goods and services due to the costs being too high, ultimately worsening the overall condition of the economy because of the subsequent fall in the demand for those goods and services. In response, employers may reduce staff, which leads to further unemployment.

Is inflation entirely terrible then?

It is important to note, however, that a low and steady amount of inflation is actually regarded by economists as a necessity for a healthy economy, because it reduces the cost of borrowing money and, more importantly, drives economic growth by boosting consumer demand and consumption. For that reason, some inflation is better than no inflation at all.

Dealing with inflation

Monetary policy can be implemented to address inflation. When inflation increases past a point that the central bank is comfortable with, they can raise the interest rates... causing a multitude of effects.

Principally, higher interest rates will increase the cost of borrowing from lenders. Higher interest rates incentivize further saving rather than spending. From businesses to individual consumers, economic activity will gradually decrease as interest rates grow. As the economy slows down, so too will the inflation rate. Conversely, if the central bank believes that the economy could benefit from stimulation, it can decrease the interest rate. Lower interest rates will incentivize further borrowing and spending, and serve well to gradually increase economic activity.

How can you prepare for high inflation?

While there is very little that an individual can do to combat high inflation, there are many ways in which they can protect themselves against it. First, investing in select stocks can be a very effective approach to fighting inflation. Some of the finest stocks to hold during an inflationary period would belong to businesses that can naturally raise their pricing. For example, goods like metals and oil have strong pricing power. When compared to other consumer goods like graphics cards, which are subject to manufacturer and distributor pricing revisions, the prices of these goods typically increase with time. Additionally, owning real estate is an effective way to hedge yourself against inflation; as the ability to increase your rent is a solid way to increase future cash flow to match the rise in cost of living. Of course, all of this preparation would be useless if you recklessly spend! Be mindful of your budget, and avoid purchasing goods that have spiked, temporarily, in price. 

That’s all for this submission. Thank you for reading, and be sure to tune next week for the letter J!

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