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Inflation: The destoyer of worlds

June 19, 2024
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FinMeUp
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FinMeUp

Quick look at inflation and what you can do to manage it.

 

What is inflation?
Remember how much you paid for an ice cream as a kid? How cheap was that compared to what you pay today? Well, that right there is inflation. Inflation is the general increase in the prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods. 

Why is it a problem?
Inflation can be a concern because it makes money saved today less valuable tomorrow. Essentially eroding the purchasing power of a currency. For example, if an investor earns 8% from his investments, but inflation is 6%, it means that his wealth only increased by 2% in real terms. 

What drives inflation?
There are three drivers of inflation: Cost-push inflation, demand-pull inflation, and built-in inflation.

Cost-push inflation occurs when prices increase due to increases in the cost of production inputs, such as raw materials. For example, the Russian-Ukraine conflict has led to a sharp increase in the prices of commodities, like oil and wheat. Oil is used in production processes and transport, and wheat is used as an input to produce food. Businesses will pass on the higher costs of raw materials to consumers, leading to higher prices without any change in demand for the products consumed.

Demand-pull inflation can be caused by strong consumer demand for a product or service. When there's a surge in demand for a wide breadth of goods across an economy, their prices tend to increase. Possible causes for increased demand include lower interest rates (more borrowing), quantitative easing from governments, population growth and income growth.  

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers expect that they will continue to rise in the future at a similar rate and demand higher wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor continually induces the other.

How do we calculate inflation?
The main measure we use to calculate inflation is the Consumer Price Index, or CPI for short. The CPI is the price of a basket of goods and services purchased by the average household in South Africa. There are 412 goods and services in the basket which are classified into 12 broad groups, such as food, beverages, clothing and footwear, health, transport, and education. We track inflation by the percentage change in the value of the basket over time. For example, if the CPI value in April 2021 was 102.5 and 108.65 in April 2022, this represents a 6% year-on-year increase.

Does the villain have a good side?
An optimum level of inflation is often promoted to encourage spending instead of saving. If the purchasing power of money decreases over time, there may be a greater incentive to spend now instead of saving and spending later. Spending leads to economic growth.

Protection against inflation
The best way to protect ourselves against inflation is to keep investing. Investments generally outperforms inflation, whilst keeping money in cash or savings erodes value over time.


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