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Inflation & Deflation: Causes and Effects

Let’s talk about two of the key indicators of an economy’s health

Inflation is frequently talked about, particularly in time of crisis and recession. Some people think it aids economic growth, others believe it’s an institutionalized robbery. We’ve made it our goal to get to the bottom of the subject and figure out ways to safeguard your money.

What is Inflation

Inflation is a process when a currency’s purchasing power weakens as the monetary supply exceeds the demand. In other words, people have more money on their hands, yet they aren’t buying as much as they’re expected to.

Inflation is conventionally divided into official and actual. The difference between the two types will determine your income. To get a better understanding, let’s take a look at the way each one is calculated.

How inflation is measured

Official inflation is based upon the consumer price index (CPI), i.e. by the changes to the price level of market basket of consumer goods and services purchased by households. CPI and the associated inflation are calculated in two steps:

  1. Establishing the contents of the market basket. It’s approximately comprised of 500 items, ranging from a sack of potatoes to a basic blood workup.
  2. Gathering data on the prices of items in the basket throughout the country. The percentage difference between last year’s figures and the current ones will represent the official inflation rate.

For the sake of an example, let’s say the market basket last year came down to $1000. This year, however, it’s worth $1100. That means the price has risen by 10%. The annual inflation rate is — you guessed it — 10%.

The difference between actual and official inflation

The government approach to calculating the inflation rate is pretty straightforward and reflects the general situation for the population as a whole. However, that in itself creates a problem as «average» consumer spendings may differ from your personal ones by a whole lot.

The reality is your personal market basket may go up in price twofold compared to the average one. Meanwhile, your salary would only be increased according to the official inflation rate. There are two ways you could go about this: you have to either increase your income or lower the expenses. We’ll talk more about it later in the article.

Causes for inflation

We have established that inflation emerges as a result of disproportion between public supply and demand. Now let’s look at the origins of this disproportion.

  • Refinancing Rate. Central Banks lend money to the credit institutions under a certain interest. That interest is known as the refinancing rate. The lower the rate — the more affordable the loans will be to the public. Loans and mortgages are a source of additional money circulating the market.
  • Market monopolies. The weak anti-monopoly legislation does nothing to prevent monopolies from dictating their price levels, affecting the price of the market basket and in turn — shaping inflation. To put things into perspective: monopolies drive the prices, the market basket gets more expensive, the inflation rate rises.
  • State budget deficit. Whenever the expenses exceed the revenue, the state starts printing additional money or issuing loan securities to the banks and individuals. That leads to an increase in monetary supply, while the trade volume remains the same.
    Military and emergency expenses. Additional spendings for defense or emergency purposes eat into the national income. Once again, the monetary supply begins to exceed the circulation of goods.
  • Devaluation of the national currency. If a currency depreciates against the other ones, the cost of imported goods rises. Export volumes grow, while internal supply diminishes. As a result, internal prices rise and the market basket gets more expensive.
  • Projected inflation. In an environment where the prices are rising the people start stocking up on goods in fear of further price spikes. Aggregate demand increases rapidly, which further marks up the prices for the market basket.

How to counteract inflation

Set up a savings account. It’s the easiest way to counteract inflation and increase your savings by up to 8% annually.

Purchase bonds. A bond is a security issued either by the state or a business whenever it loans money from a private individual. Holding one can earn you up to 12% annually.

Investing in stocks. While bonds are confirmation of a loan, stocks are storages of value on their own merit. By purchasing a company’s stock, you’re becoming an investor and can make money off of that company’s revenue growth. The returns on such investments may vary, but the risks are always quite high.

Request fiduciary management. You may want to confide your money to the experts, the people who know how to multiply it. That service, obviously, comes at a price: you’ll have to pay the fiduciary a portion of your profit.

What is «deflation»?

Deflation is the opposite of inflation. The purchasing power of a currency is growing, while the prices are going down. Deflation is usually evident from CPI calculation for a particular month or a quarter, but the year overall normally ends with inflation.

At a first glance it may seem like deflation is a good thing — you can afford more for the same amount of money. In practice, however, it’s more harmful to the economy than inflation is

The dangers of deflation

  • Deflation makes demand go down. People are in no rush to buy expensive goods fearing those could only get more expensive. This causes businesses to slow down their growth and the economy as a whole stall as a result.
  • Businesses shut down. Production volumes plummet and the goods that have already been produced remain on their shelves.
  • Household incomes decline. Lower demand hurts businesses and forces them to lower salaries and lay people off.
  • Purchasing ability goes down. Deflation does make goods and services cheaper. However, household incomes decrease faster than the prices do.
  • The economy slows down. Banks cut back on the number of credit lines, both to private individuals and businesses. Taking out a loan becomes more difficult and ends up costing more in interest money.

Counteracting deflation

Central Banks can lower the refinancing rate to rejuvenate the economy through lending to businesses. In turn, money becomes more accessible to individuals, which boosts public demand. Another thing that can be done at the state level is easing up on the taxes and issuing more state bonds.

As a result, prices will stabilize and the people will have more disposable income, which will benefit businesses. Everybody wins!

Let’s recap

Actual inflation can be different from the official one and that will make a difference in your income.

Inflation can have many causes, most of which you’ll have no power over. That’s why it’s advisable to pay particular focus to your personal finances at that time.

There are several ways to safeguard your income during the times of higher inflation: savings accounts, stocks and other securities, fiduciary money management, cashback and controlling your spending.

Deflation is more dangerous than inflation, but thankfully it doesn’t happen too often.

About author
Product manager @Moneon. Working hard at solving puzzles of the world of finance, so you don't need to.
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