What should you know about Inflation?

If you consider the economic definition for inflation, it refers to a persistent increase in prices of goods and services in an economy spread over time. This is relatively simple; the groceries and vegetables you buy will become more expensive. But the impact of inflation goes deeper than that. When inflation rates remain high over long periods or when the change in inflation becomes too sharp too soon, it can alter your purchasing power and shift focus away from productive use of FUNDS. Here is how sustained high inflation can impact lives. 


Purchasing power

 Every economy has a benchmark price index, which measures the change in a defined basket of “stuff”, which is most representative of the economy. 

An inflation rate of 5% means that the same unit of MONEY is now worth that much less. Year after year, inflation eats into the value of your MONEY and reduces its ability to buy the same basket of goods from, say, five years ago. If your income growth keeps pace with inflation, you will not feel the impact much.

 But economists suggest that the origin of inflation doesn’t lie simply in higher prices, which could be caused by demand-supply dynamics, rather it is a result of prices nudged higher by increased MONEY supply. Increase in money supply without a corresponding increase in demand and production of goods and services leads to a higher amount of cash chasing the same amount of “stuff” and this leads to higher prices. As a result, increased money supply leads to a fall in the value of money and its purchasing power. Thus, ultimately, sustained high inflation will reduce the value of your money and how much it can buy.

 Interest rate 

To keep inflation under control and not let prices rise too much too fast, central banks across the globe use monetary policy. One of the actions of a monetary policy is to adjust the rate of interest in the economy. The main rate of interest is the one at which the central bank lends to and borrows from other commercial banks. This determines the cost of money for commercial banks and the rate at which they lend to customers, and the deposit rates.

 In periods of sustained inflation, there is a need to control the amount of MONEY available to people in an economy. This will reduce excess money chasing a limited amount of goods and services. This can be achieved if the central bank elevates the rate at which it lends to other commercial banks, thus MAKING MONEY more expensive. The banks, in turn, increase their lending rates for customers. 

Thus, high inflation will lead to high interest rates on your borrowings and will not allow you to use the leverage to your advantage for financing assets. On the flip side, any interest or return you earn on assets will also get diminished to the extent that inflation eats into its value. 

Ultimately, high inflation not only reduces what one unit of money can buy, but it also reduces your money’s earning power thanks to lower real rate of return (rate of return less inflation rate). At the same time, you pay more interest on your liabilities, thus preventing your money from becoming productive.


Source:Livemint.com