What is Inflation? Here is How it Impacts You

11 April 12:11

What is inflation?
Inflation is a broad term used to explain the rise in prices, but not of value. It indicates the general continuous rise in prices of a series of goods and services essential to people’s daily lives.

What causes inflation?
Main causes: the rise in a product’s demand, production costs, emission of currency and reduction of local rates.

How does inflation affect you?
Things get more expensive while the amount of money you earn to buy them remains the same. It also distorts prices and makes it more difficult for people to keep up with their regular living costs.

Can we control inflation?
Governments can never have complete control over inflation, but there are certain measures they can use to reduce its impact. Increasing investment rating rewards in fixed income and government treasury bonds, for instance, motivates people to save their money and invest.

Is inflation good or bad?
Inflation is only bad when out of control at really high and unexpected rates. When its rise is gradual and barely noticeable to the general population, it’s one of the strongest indications for companies that a particular economy is growing and is a safe place to invest and set up businesses.

The word “inflation” seems to be always involved in topics of financial discussion, especially over the past few years. Whether it’s in the Western or Eastern economies, traditional markets or cryptocurrencies, the topic seems to always find a way to become part of discussions around investments.

Although it’s one of the most used words in finances of the past couple of years, what is it really, and how does it impact people’s lives? In this article, we discuss what inflation is and the impact it has on the lives of people like you and me.

What is inflation?

Inflation is a broad term used to explain the rise in prices, but not of value. Although mostly related to prices of retail products, it can be related to rent, real estate, cars, salaries and is the main reason why purchasing people fluctuates - despite their earnings remaining the same on paper.

In a nutshell, it indicates the general continuous rise in prices of a series of goods and services essential to people’s daily lives. In the American economy, such a series of goods and services is called the “Basket of Goods,” measured by the US Consumer Price Index (CPI) every month. It constitutes products such as alcohol, transport, fuel, housing, clothing, recreation and more.

For instance: if the inflation rate of a determined year was 7%, it means that the average rise in consumer prices during that period was also 07%. If in 2021 you were looking to buy a brand new $10,000 dollar car, in 2022 that same vehicle could be costing $10,700 dollars. Doesn’t sound like a huge difference when looking at a single purchase but remember; the inflation rate affects every transaction of a person’s daily life, every day. With time, it accumulates into a tremendous difference.

What causes inflation?

In order to understand what causes inflation, it’s important to know that not all inflations are the same. As standard measure practice, economies are usually measured in two types; short-term inflation - which may increase over a monthly period - and long-term inflation - which can rise continuously for one, two, three years or more. These are cyclical moments in any economy, where one will always have an impact on the other. It’s not always possible to isolate the causes of an inflationary variation, but here are the standard reasons for the usual short and long-term effects.

Causes of short-term inflation

· Rise in a product’s demand: if demand for a product increases drastically, it’s more difficult for companies to supply the item to all their customers. In this case, they tend to raise prices, causing inflation.

· Rise in production costs: say an important material in building construction has become scarce as of late. Companies that provide raw materials then raise the prices, making construction more expensive throughout the globe.

Causes of long-term inflation

· Rise in currency emission: when a government’s expenditures are higher than what they are able to afford, it’s quite common to “print” more money, that is, to provide more circulating currency available to pay the bills. The US Federal Reserve, for instance, printed in 2020 and 2021 alone about 25% of all the US dollars currently in circulation.

· Reducing rates: when a government reduces rates as a means to secure more funding, people’s investments in fixed income are reduced and treasury is reduced while loans tend to get cheaper as a means to incentivize the local economy. While it’s a helpful and known strategy to stimulate consumerism and production, in the long-term it leads to a high increase in general demand which usually results in long-lasting inflation.

How does inflation affect you?

Gas prices in the United States recently hit an all-time high. Source: Poynter

To put it simply, things get more expensive while the amount of money you earn to buy them remains the same. It’s called asset depreciation, which leads to a loss in purchasing power. Inflation also distorts prices and makes it more difficult for people to keep up with their regular living costs. In situations of hyperinflation, as seen recently in Venezuela and Argentina, prices get much higher on a daily basis and may lead to a complete loss in people’s grips of their resources and means to survive.

A recent example of rapid short-term inflation was seen in the United States. As a result of the current conflict between Russia and Ukraine, the US stopped importing oil for fuel from Russia. In merely two weeks after the decision was made, gasoline prices rose by a staggering 22%, affecting personal and industrial transport logistics all over the country.

How inflation affects the crypto market

US inflation rate over a hundred years. Source: Khan Academy

The way inflation affects crypto is similar to how it affects investments and different financial markets as a whole. The reality is; it depends. It depends on the other factors that are leading to high inflation, it depends whether if it’s short or long term, and of course it depends on how high the inflation rate is.

Most of the times, inflation actually leads to more people investing in high-risk assets, which includes stocks and cryptocurrencies. That’s because trading your leftover funds for potentially appreciating assets is usually a better deal than just letting it sit in an account and slowly lose its purchasing value.

As an example, we have the current Covid-19 economic crisis. When it was first announced that the world was officially entering a pandemic, all markets plummetted almost immediately. Then, countries started offering financial support for their populations, including stipends and welfare checks to get by as the planet entered several lockdowns. During this period of government incentives, like bonds and and federal rates that we mentioned previously, markets shattered the previous ceilings - the crypto market reached three trillion dollars, while indexes like Nasdaq, S&P 500 and Dow Jones broke all past records.

By backtracking past experiences with inflation, like the image shown above, we can form a parallel between periods of high inflation and also high consumerism and investments. The high inflation period of the 1950s till early 1980s was the peak of the so-called American dream, where all markets were heading up and stocks continued to break records. Once inflation is low, it’s very favourable for populations to use the money rather than reinvest it. It’s no wonder that Bitcoin reached its recent all-time high in November of 2021, slowly descending since then along with stock markets once governments all over the world announced that they were taking measures to fight inflation. Inflation leads to more spending and, for those that have lots of money left overs, to relocate their wealth to appreciating assets rather than fiat currency.

Can we control inflation?

Yes and no. Governments can never have complete control over inflation, but there are certain measures they can use to reduce its impact. Increasing investment rating rewards in fixed income and government treasury bonds, for instance, motivates people to save their money and invest, resulting in fewer dollars available in circulation which hopefully deflates the asset. Raising taxes can work the other way around, motivating people to spend more while what’s left of their income is greater kept by the government - inducing inflation.

It’s valuable to note that these decisions are anything but simple, and each resolution has several ramifications that can potentially lead to long-lasting problems in a country’s economy. Nothing is black and white when it comes to inflation, and every decision has a consequence to balance it out.

Is inflation good or bad?

When kept under control and rising at a slow and steady pace, inflation is a great indication that a country’s economy is growing, with consistent spending and people’s purchasing power following a healthy rate. Contrary to popular belief, deflation - the opposite of inflation - is terrible for any nation. If prices are constantly decreasing, then people choose to not spend any money because they can always buy later at a better price. As a result, businesses don’t profit, goods and services stagnate and the economy shrinks.

Inflation is only bad when out of control at really high and unexpected rates. When its rise is gradual and barely noticeable to the general population, it’s one of the strongest indications for companies that a particular economy is growing and is a safe place to invest and set up businesses. Therefore, it really is all about balance.

Author: Gate.io Researcher: Victor Bastos
* This article represents only the views of the researcher and does not constitute any investment suggestions.
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