Inflation

Inflation and Its Impact on Your Purchasing Power

Inflation can make everybody’s money go less further than it used to. It is an economic condition where prices of goods and services are slowly increasing, and the purchasing power of your money gradually drops over the long run.

Here’s more information about inflation and some ways to protect your money’s value amid a price rise.

Inflation Explained

Inflation refers to the broad surge in prices across the economy, which weakens the purchasing power of everybody’s money.

Such a situation involves more than prices for a single product or service. The price increase spans a sector or industry, such as energy, petrol, construction, and the whole economy of a country.

In the US, inflation has three key indicators: the consumer price index (CPI), the producer price index (PPI), and the personal consumption expenditures price index (PCE).

Those three key metrics use different gauges to monitor changes in prices that consumers pay, and producers receive in industries across the entire US economy.

  • CPI – Tracks the monthly percentage change in the price of a basket of goods and services consumers pay.
  • PPI – Measures the average change in the prices paid to producers of goods and services. PPI, which is published by the Bureau of Labor Statistics (BLS), is an indicator of wholesale inflation.
  • PCE – Measures inflation, including all goods and services purchased by households for consumption.

While it’s not good news to know that your dollar’s value is declining, many economists welcome a bit of inflation as it can indicate a healthy economy. Moderate inflation signals the time to spend or invest instead of keeping your money and seeing it slowly lose value.

On the other hand, extreme inflation is detrimental to a country’s economy. If inflation is not controlled, it could lead an economy to collapse. For example, Venezuela’s inflation rate reached over 1,000,000% a month, pushing the economy significantly down and prompting citizens to leave the country.

Understanding Deflation

Deflation occurs when prices broadly decline across a sector or the whole economy.

During deflation, you can buy more goods or services for less the price. However, compared to excessive inflation, deflation can be riskier for an economy.

When deflation takes place, consumers put their planned purchases on hold in anticipation of prices dropping further in the future. If deflation is not curbed, it can weaken or bring economic growth to a halt, resulting in reduced wages and a frozen economy.

Hyperinflation and Stagflation Explained

Hyperinflation or stagflation is usually the result of unchecked inflation, which hurts an economy and consumers’ purchasing power.

Hyperinflation

Hyperinflation refers to the rapid, excessive surge in the general prices of goods and services, with the value of a country’s currency taking a sharp dive. This type of inflation is determined by prices going up by at least 50% every month.

Hyperinflation rarely happens, but such a situation has happened during civil unrest, war, or when there is a new regime, making the currency worthless.

One famous example of hyperinflation was in Weimar Germany in October 1923, when the country hit a monthly inflation rate of about 29,500%, which heavily weighed down the German economy.

Stagflation

Stagflation involves a high inflation rate, although the country’s economy shows no growth, and there is an increase in unemployment numbers.

Typically, when the jobless rate climbs, consumer demand falls as people rein in on spending. That drop in demand pushes prices down, allowing your purchasing power to readjust.

However, with stagflation, prices stay high despite reduced consumer spending, making purchasing the same products or services gradually costly.

One example of stagflation occurred in the US in the 1970s, when energy prices rose significantly due to embargos headed by the Organization of the Petroleum Exporting Countries (OPEC).

That resulted in higher inflation in the world’s largest economy despite a recession leading the country’s gross domestic product (GDP) down and unemployment up.

Inflation Triggers: Demand-Pull and Cost-Push Inflation

Demand-pull and cost-push inflation are two common ways a gradual rise in prices associated with inflation can be triggered.

Demand-Pull Inflation

Demand-pull inflation refers to a surge in demand for goods or services, with supply staying the same or decreasing. If supply is unable to keep up with higher demand, prices soar.

Demand-pull inflation can be due to several reasons. People and companies produce more money during a healthy economy.

Such a boost in purchasing power allows consumers to acquire more than they could before, strengthening competition for existing goods and driving prices higher while companies try to increase production.

Demand-pull inflation on a smaller scale can be because particular products or services suddenly gain tremendous traction.

Cost-Push Inflation

Cost-push inflation is a situation where the supply of goods or services is limited or has shrunk while the demand is unchanged, prompting prices to climb.

External events, such as natural disasters, often prevent companies from manufacturing enough certain goods to meet consumer demand. That enables them to raise prices, leading to inflation.

For example, with oil prices, just about everyone requires a particular amount of petrol to run their vehicles. So when global agreements or calamities result in a major cut in oil supply, prices rise as demand stays the same despite a decline in supply.

Inflation expectations can also be crucial to inflationary impacts. If a company expects future inflation to climb and takes steps based on that prospect, they may accelerate the price hikes of their products and services.

Beating Inflation Through Investing

The purchasing power of money held as cash or kept in bank accounts with low interest eventually weakens even if the country is only facing moderate inflation. Still, you can protect your purchasing power from the impact of inflation by investing in particular assets.

Stocks

Holding stocks is one way to potentially counter inflation. Individual stocks could slide, single companies could close down, and bear markets could weigh down indexes for some time. However, broader stock market indices can post gains over the long term, fighting off inflation.

While individual stocks are not a surefire way, having excellent diversity in your investment in a broad stock market index fund allows you to grow your money in the long run and gain a hedge against inflation.

Bonds

On average, bonds offer lower returns than stocks, but they are also excellent financial instruments for beating inflation. So if you’re the conservative type of investor or about to retire, the more consistent returns provided by bonds would be suitable for you to beat inflation.

Gold

While many investors see gold as the best hedge against inflation, this matter remains open for debate. Still, market players choose to invest in a gold exchange-traded fund (ETF) or other precious metal.

Keep in mind that gold’s price can wildly fluctuate over the long term and is affected by movements of global currencies, monetary policy decisions from the Federal Reserve and other central banks, and supply and demand.

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