Inflation is well defined as a sustained increase in the general level of prices for goods and services wherein the purchasing power falls. It is measured as an annual percentage increase. As inflation rises, every penny you own buys a smaller percentage of good or service. Banks attempt to limit inflation and avoid deflation to keep the economy running smoothly.
The value of money is not constant when there is inflation. Its value is determined in terms of purchasing power which is tangible goods that money can buy. While inflation goes up, there is a decline in the purchasing power of money.
There are several variations on inflation
- Deflation is when general level of prices is falling. This is opposite inflation.
- Hyperinflation is rapid inflation wherein in some cases it may lead to breakdown of a nation’s monetary system.
- Stagflation is the combination of high unemployment and economic stagnation with inflation.
Breaking down inflation
As a result of inflation, the purchasing power of a currency falls. As goods and services require money for purchasing, the embedded value of money falls. Monetarism explains that inflation is related to money supply of an economy.
Inflation in Moderation - Pros and cons
Pros of Inflation
- Deflation or negative inflation is harmful
When prices fall, people are reluctant to spend money as they are concerned that prices will be cheaper in future. Therefore, they keep delaying purchases. Deflation also increases the real value of debt and reduces disposable income of individuals who struggle to pay off debts.
- Moderate inflation enables adjustment of wages
Moderate rate of inflation makes it easier to adjust relative wages. When wages are rising due to moderate inflation, it is easier to increase the wages of productive workers wages. Unproductive workers have their wages frozen which is effectively a real wage cut.
- Inflation boosts growth
During very low inflation the economy may be struck in a recession. Targeting a higher rate of inflation enables a boost in economic growth.
Cons of Inflation
Inflation is usually considered to be a problem when the inflation rate rises. The higher the inflation the more serious the nature of problem. In extreme circumstances hyperinflation can wipe away savings of the people and cause instability. Inflation is usually accompanied with higher interest rates, hence savers do not see their savings wiped away. However, inflation can still be problematic.
- Inflation tends to be unsustainable leading to a damaging period of booming economic cycles
- Inflation tends to discourage investment and long term economic growth. It is due to the uncertainty and confusion that is likely to occur during periods of high inflation. Low inflation encourages greater stability and inspires firms to take risks and invest.
- Inflation makes economy uncompetitive.
- Reduces value of savings. It leads to fall in the value of money. Higher inflation leads to redistribution of income in the society. It is a problem when inflation is high and interest rates low.
There is a risk involved in inflation. Bond issuers can default and companies issuing stocks can go under. It hence becomes important to do a solid research and create a diverse portfolio. In order to keep inflation from steadily growing it is important to invest in assets that can be reasonably expected to yield greater rate than inflation.