Inflation is an economic term that means the decline in purchasing power of a particular currency.
- Inflation occurs when a rise in general level of prices, often expressed as a percentage, means that a unit of currency can buy less than it did previously
- It typically comes in three different types: demand-pull inflation, cost-push inflation, and built-in inflation
- The process of inflation can be a postivie or a negative depending on your own circumstances and investments
What is inflation?
Inflation is the rate at which a fiat currency – such as GBP, USD or EUR – is falling in value. That means every unit of that currency is able to purchase fewer goods and services than it would previously have been able to, meaning it has lost purchasing power.
While individual prices will rise and fall in a market economy, inflation reflects upon the general price of all goods and services. It is typically presented as a percentage.
The inflation of a currency is caused by a variety of economic and social factors, and these typically include the increased supply of money, devaluation, rising wages, and new policies and regulations.
The three types of inflation
More broadly, inflation tends to come in three forms. Demand-pull inflation is when an increase in the supply of money and credit leads to demand outpacing supply. As a result, prices rise and currencies are worth less than they were before.
Cost-push inflation occurs when the price of production increases due to more expensive labour or materials. For instance, when it becomes more expensive to extract oil and gas, the price of petrol increases, inflation occurs because your money is able to acquire less fuel than it was before.
Finally, there is built-in inflation. This is a type of inflation that occurs because of past events and persists in the present. Essentially, businesses and consumers automatically include a predicted percentage in their costs because of the economic activity of yesteryear, meaning companies increase their prices, and workers expect – and demand – increased wages.
How do we measure inflation?
Several prices indexes are key benchmarks when it comes to measuring inflation. The Consumer Price Index (CPI) is a measure that examines a weighted average of prices of a selection of goods and services that have been determined to be primary consumer needs.
Then, there is the Wholesale Price Index (WPI), which looks more closely at the front end of the production process. It measures and tracks the changes in the price of goods in the stages before they go on sale.
Finally, there is the Producer Price Index (PPI), which measures the average change in selling prices received by producers of goods and services over time. By monitoring these indexes closely, you can get a better idea of the inflationary mode an economy is in at any given time.
Is inflation bad?
That really depends on your own personal circumstances. For instance, if a seller owns a tangible asset, such as real estate, inflation can increase its price, allowing the seller to offload their asset for more than they paid for it. However, on the other side of the aisle, buyers will be left frustrated by rising price tags.
Moreover, those who hold assets denominated in currency, such as cash in the bank, will find that the real value of their holdings will be eroded by inflation. By contrast, those who hedge their portfolios from inflation with safe-haven assets like gold and real estate investment trust (REITs) will be more at ease.
Overall, it is key to exercise a balanced approach when making financial decisions in light of inflation. While many economists view accelerating inflation as a recipe for long-term economic problems, hedging your portfolio and making diligent financial decisions can help alleviate negative consequences, and in some instances, it can even increase your returns.
Where can I learn more?
For more information about inflation, check out our stock investing hub page. You can also learn more by heading over to our courses which explore inflation in more detail and explain the investment strategies you should adopt to benefit from it.
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