What is Inflation?
INFLATION
In its simplest sense, inflation is the rate at which the price of goods and services increase and the resulting decline in purchasing power of a select currency. On the opposite end of this spectrum is deflation, which is the rate of decline in the prices of goods and services and the resulting rise in purchasing power of a select currency. Inflation is measured using a consumer price index or CPI, which tracks the prices of a basket of core goods and services.
What does it mean for you?
Inflation results in you spending more units of a given currency to purchase goods or services. The need to spend more units is as a result of the rise in prices. This therefore means that you will have less money to purchase further goods and services. Hence, a decline in your purchasing power.
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For example, if inflation is 4% and a product cost $100.00 in a given year it will now cost $104.00. When this is compounded over many years it can lead to a dramatic fall in purchasing power of a given currency.
Do we need inflation?
After gauging the above definitions, one may ask if inflation is a bad thing and if so why are Central Banks hellbent on pushing it. Well, inflation is used to drive economic output and therefore reduce unemployment. Higher prices mean more profits for companies which results in greater uptick in employment. But this is not sustainable as we will see below. On the other hand what’s wrong with deflation?
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The fear around deflation is that it can result in a stagnation of the economy like what was being experienced in Japan. There is a wild expectation among politicians, economist and Central Banks that countries can consistently be growing. One may argue that this defy’s the laws of physics. What goes up must comes down. What is down and the rate of the down is what we should be aiming to managed. Not consistently aiming to grow like there is no tomorrow if key fundamentals are stable. In June 2018, Japan’s unemployment rate was 2.4%, budget deficit was -4.5% in 2017 (-9.5% in 2008). That is pretty stable to me. If inflation is being used as an indicator of economic growth, why rely upon it if maximum employment is reached?
What are the drivers of inflation?
Milton Friedman, an economist, can be seen as the main voice that drove the concept of inflation being tied to monetary supply and not directly to prices themselves. It is theorized that the steady increase in the monetary supply, meaning the printing of money will increase economic output and therefore reduce unemployment.
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This activity led Friedman to conclude that prices do not drive inflation but rather the monetary supply. It was this printing of money which then drives up prices causing inflation. This event has been repeated consistently throughout history.
So why print money?
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Since currencies are no longer tied to a physical asset, its value is determined by the economic output of a country. To generate economic output you need people to access capital in order to engage in activities that will produce this output. Hence, the printing of money. The structure under which this is done is known as monetary policy. Therefore we will always have a system of sustainable inflation being pushed for. Milton Friedman suggested inflation was generated to achieve three things:
- Pay for government spending
- Pay for debt
- Promote full employment
Let’s explore the second point given. We will speak more on the other points in later articles. Debt, specifically sovereign debt can be argued to be a major driver of inflation. How so? If a country borrows money in foreign currencies, one ill-advice way of paying back those debts is by printing money of the given currency and then convert it into the foreign currency to meet those debt payments. The printing of the money results in an increase in money supply which reduces the value.
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This is due to greater currency units in circulation. This reduction of value forces merchants to increase their prices which further exacerbates the problem. This can results in Hyperinflation and it is currently being witnessed in Venezuela. It also results in a decline in a nation’s reserves.
Negative Consequences of Inflation
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In today’s world of fiat currencies inflation is more than just the rise in the prices of goods and services as it is also impacted by money supply. One can argue that inflation is a zero sum game. Meaning no one really gain or lose and the gain or loss is simply exchanged. For example, recently in Jamaica wage negotiations for public sector workers concluded and a wage increase of 2% was given for the financial year 2018/2019. Ending July 2018, point to point inflation was 3.21%. Hence,if this rate continues there will be no gain. In fact, there will be a net lost of 1.21%. Meaning, the purchasing power of workers will declined.
The constant decline in purchasing power put pressures on businesses to increase wages. To compensate for the rise in wages businesses increase prices and the vicious cycle continues. Businesses that wish not to be a part of this cyclical effect, will make a mad dash to automation, which results in a reduction in the labour. For some businesses the response will be to relocate overseas. Therefore, the sustainability is called into question. In the end is inflation at any level really worth it?
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The printing of money may give a short term boost to economic growth due to the presence of cheap credit, but longer term effects on prices are clear and the resulting inflation is unstoppable.
Investing is your only hope
To protect your money from the corrosive effect of inflation assets are needed. To put this in simple terms, between September 8, 2017 and September 7, 2018, if you had invested in stocks weighed to the JSE index on the Jamaican Stock Exchange, your money would have grown by 26.82% (See how the stock market works). So your net gain on your money minus the point to point inflation of 3.21% would have been an impressive 23.61%. That is a gain for you, your family and your future.
TEST YOUR KNOWLEDGE
What is used to measure inflation?
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