What is Inflation? The Ultimate Guide

As the economy rebounds from COVID-19 closures and shutdowns, one of the biggest fears on the minds of many economists is high inflation. The United States (and much of the global economy) is in a unique place in its economic history. Americans have seen an unprecedented amount of government money flow into their bank accounts while supply chain crises have caused shortages of everything from semiconductors to lumber.

Is the US about to enter a period of extended high inflation? Economists are split on the idea, and the Federal Reserve insists the rate of inflation will drop once supply chain issues resolve. But for the time being, higher prices are likely to be a way of life for Americans. But what exactly is inflation, and what causes it? Does anyone actually benefit from inflation? In today’s post, we’ll examine how inflation seeps into an economy and discuss potential ways to protect purchasing power.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

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How Does Inflation Work?

Inflation can be defined as a rise in prices that decreases the purchasing power of a unit of currency. Basic economics can help explain how inflation functions: when cash is abundant and goods and services are scarce, the price of those goods and services will increase as consumers are willing to pay more to get them. One of the most common examples usually involves looking at the price of a newspaper or movie ticket in 1920 and comparing it to the cost of the same item today. Of course, no one in 1920 made today’s wages either, so this example usually misses the main concern about inflation: the rate of price increases over time.

Too much inflation is obviously bad, but what about slow and steady inflation? Most economists agree that a low inflation rate is the “price” we pay for a robust and expanding economy. Moderate inflation encourages investment since spending today can increase purchasing power tomorrow (or decades down the road). Moderate inflation also means an increase in wages, since workers will demand more compensation to counteract the heightened cost of living.

Inflation vs Deflation

The opposite of inflation is deflation, when prices decrease and purchasing power climbs. Hey, that sounds good, right? Everyone wants lower prices. But deflation tends to create a hoarding effect as consumers hold on to their dollars in anticipation of lower and lower prices. Why buy a house today when it will be cheaper in a year? This creates a freezing effect on the economy, which stifles growth and discourages investment. Low growth and low investment means businesses are forced to cut prices and accept lower profit margins, which inevitably results in negative events like layoffs and wage reduction.

Types of Inflation

Inflation may be loosely defined as too many dollars chasing too few goods, but this doesn’t really get to the root cause. What actually causes inflation? Economists usually explain the origins of inflation through one of these two methods:

  • Cost-Pull Inflation. When demand remains the same but supply is constrained, the result is called cost-pull inflation since the constrained supply is usually caused by increases in raw materials or production costs. If the price of lumber rises, it becomes more expensive to build homes, so average home prices will increase even if demand remains constant.
  • Demand-Push Inflation. Now let’s do the reverse: when demand increases rapidly while supply remains constant, demand-push inflation comes into play. When consumers experience an influx in capital and supply does not increase, people will be willing to pay higher prices since there will be more competition for goods and services.

Winners and Losers During Periods of High Inflation

Does anyone actually benefit from high inflation? Not really, but it does hurt some more than others. Here are the usual winners and losers during periods of high inflation:

Winners

  • Asset Holders. If you hold assets like stocks, real estate, or precious metals, you may not gain purchasing power during a high inflationary period, but you’ll certainly lose less purchasing power than those who park their cash in savings. An expanding inflation rate will boost the demand for assets like stocks, which in turn sends prices higher.
  • Fixed Rate Debt Holders. If you have a fixed rate mortgage, student loans, or even a manageable amount of credit card debt, inflation could reduce the purchasing power needed to repay these debts. If your income rises while your liabilities remain fixed, it takes less and less purchasing power to meet your obligations.

Losers

  • Retirees on Fixed Incomes. One of the reasons retirees greatly fear taxes and inflation is because they’ve exhausted their human capital and now rely on a fixed amount of capital. Retirees who try to keep spending at a fixed annual rate suffer greatly when inflation is high.
  • Low- and Middle-Income Citizens. Inflation helps those with fixed rate debt, but that doesn’t mean it’s a boost to the lower income classes. If you don’t have financial assets to back up your loss in purchasing power, inflation will hit harder, especially at places like the gas pump and grocery store. Lower- and middle-income workers are less likely to be able to jump jobs for a better salary or demand a raise at their current job. They’re also more likely to commute and not have Work-From-Home options, further increasing their cost of living.

Speak With a Financial Advisor

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

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Disclosure

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.