What is Inflation & How Does It work?

In simple terms, inflation is the increase in the level of prices for the services you pay for and the goods that you buy. As inflation rises what you are able to buy for the value of a dollar, decreases. For example. in the late 1960’s a couple getting married and buying their first home together would look to spend around $22,500. Today that is not the cost of a new home (well in Detroit maybe), it is the cost a new car. a new car in the 60’s would cost around $3,000, yet today that is the cost of a weeks vacation for some people. If you want to go and see the latest movie release from Marvel comics or the Hobbit series, then the average movie ticket will cost you $8.50, yet in the 60’s the cost was a simple dollar. Why have prices changed so much? Because of inflation!

There are also different types of inflation. First you have deflation. This is rare and it is the opposite of inflation, therefore prices go down and you get more for your money. There is stagflation, a combination of stagnation and inflation, so this is when the economy stagnates due to high unemployment and high prices (For those who are old enough, think 1970’s America). Then the final one is probably the worst and that is hyperinflation. This is mega fast inflation and it results in the breakdown of a country’s monetary system. This is an issue that countries like Zimbabwe have experienced recently where inflation has been in excess of 2000%. Currently there are no countries with hyperinflation, however Venezuela is experiencing high inflation of around 57%, compared to the US rate which up to 16th July was zero% ( the last time it was that low was pre 2008 crash)

Check out the inflation calculator to the side to see how the cost of living has increased over the years. (calculator courtesy of cpiinflationcalculator.com )

How To Understand Inflation

What Causes Inflation?

There isn’t one simple reason for inflation, not one that economists can agree on anyway. There are a number of collective and variant reasons why inflation occurs. Supply and demand is one cause. If the demand for a product is high, but the supply is low, then prices increase and this affects inflation. So things like low supply of quality housing but a high demand for it will result in house prices increasing. A high demand of oil in manufacturing but a low supply due to possible war increases the cost of goods which increases inflation. Another way inflation is caused is a cost push. This is when a companies costs go up, they have to increase their prices to ensure they maintain their profits. So if I am a manufacturer of an item, and my supplier increases their costs, I have to increase the sale price and if it is an item that people have to have (like food) then the price level increases and inflation increases.

How Does Inflation Impact on Investments?

Well, it depends on what type of investments you have. If you are investing solely in stocks and shares, then inflation can be a positive thing for you as the company you are investing in will see their earnings increase as a result of inflation. However if a company carries a lot of cash then high inflation will impact on them in a negative way because the more cash a company has, the less purchasing power they have.

However, if you have your money tied up in fixed rate investments, unfortunately, you will be the hardest hit by inflation. For example if you have $100,000 invested in a fixed rate bond that offers a 10% return and inflation rises to 5%, then the actual return you get is 5% and not 10%. Of course, if inflation was to increase dramatically and go over 10% then the $100,000 you have invested will provide no return at all.