What Causes Inflation and Who Profits From It?
If you’ve been alive for more than a couple of years, you’ve probably experienced inflation. Inflation is defined as an increase in the prices of goods and services over time. In simple terms, when inflation occurs, there will be a rise in the prices of the things you buy on a day-to-day basis. In this guide, we will discuss what causes inflation, who benefits from it, and how you can protect yourself from its effects.
What Is Inflation?
Inflation is an economic concept that refers to the general increase in prices of goods and services over time. For example, if the price of a gallon of milk was $3 last year and is now $3.50, that’s an example of inflation. There are several impacts of this and most people feel them in their day-to-day lives. This increase can occur in any product, sector or service such as gasoline, eggs, coffee, rent, and so on.
Another way to look at this is that inflation means your dollar doesn’t go as far as it used to. Let’s say you have $100 and you want to buy a new video game that costs $60. In a period of high inflation, that same video game might cost $70 or even $80, which would leave you with less money to spend on other things.
A lot of tmes, when inflation sets in, people’s wages will also rise in order to keep up with the increased costs of living. So, if you’re making $30 an hour and inflation rises by 2%, your employer will likely give you a raise to $30.60 so that you can still afford to live comfortably.
How Is Inflation Measured?
In order to get an accurate depiction of inflation, economists rely on two key metrics: the consumer price index (CPI) and producer price index (PPI).
The CPI measures changes in prices of a fixed basket of goods and services that are commonly purchased by households. This includes items like food, housing, transportation, and healthcare. Another way to think of it is that the CPI is a measure of the cost of living. This also relates to the concept of purchasing power, which is the amount of goods or services that your money can buy.
The producer price index (PPI) looks at changes in prices for a basket of goods and services at the wholesale level. This includes items like raw materials, components, and finished products. The PPI is important because it can be used to predict consumer inflation. For example, if the cost of raw materials increases, that will likely lead to an increase in the price of the finished product. And if the price of the finished product goes up, that will likely lead to an increase in consumer prices as well.
These metrics are important because they help economists track inflation and predict future trends. Inflation is often reported as an annual percentage change. For example, if the CPI is rising by 2% per year, that means prices are increasing at a rate of 2% annually.
Drivers Of Inflation
There are two main drivers of inflation: cost-push inflation and demand-pull inflation.
Cost-push inflation occurs when the costs of production increase and businesses pass those costs on to consumers in the form of higher prices. This can be caused by things like increases in the price of raw materials, wages, or energy. For example, if the price of oil goes up, that will likely lead to an increase in the price of gasoline. And if the price of gasoline goes up, that will likely lead to an increase in the prices of other goods and services as well. This is because businesses will pass on their higher costs to consumers in the form of higher prices.
Cost push inflation has a few different impacts. First, it can lead to higher prices for consumers. This, in turn, can lead to lower consumer spending and a decrease in economic activity. Second, it can lead to an increase in unemployment because businesses will cut back on production if they’re facing higher costs. And finally, cost-push inflation can also lead to higher interest rates because central banks often raise rates in order to combat inflation.
Demand-pull inflation occurs when there is an increase in demand for goods and services that exceeds the available supply. This can lead to businesses increasing prices in order to maximize profits. For example, if there is an increase in demand for housing, that will likely lead to an increase in prices. Another way to look at this is that demand-pull inflation is caused by an increase in aggregate demand. This can be caused by things like population growth, government spending, or an increase in exports.
This type of inflation is often considered to be good for the economy because it leads to higher prices and, as a result, higher profits for businesses. It can also lead to more jobs because businesses will hire more workers to meet the increased demand. However, if demand-pull inflation gets out of hand, it can lead to things like asset bubbles and economic bubbles.
The Housing Market
The housing market is another important driver of inflation. This is because housing prices are a major component of the CPI and PPI. When housing prices increase, that leads to an increase in the cost of living for consumers and the cost of production for businesses. And when the cost of living and production go up, that leads to inflation.
The housing market is also important because it’s often used as a leading indicator for inflation. This means that changes in housing prices can be used to predict changes in consumer prices down the road. For example, if housing prices start to increase, that’s often an indication that consumer prices will start to increase as well.
Who Benefits From Inflation?
Inflation can have different impacts on different people and businesses. For example, people who own assets like property or stocks tend to benefit from inflation because their assets increase in value as prices rise. And businesses that have fixed costs tend to benefit from inflation because their costs remain the same while their prices increase.
On the other hand, people with debt tend to be hurt by inflation because they have to pay back their debt with dollars that are worth less than when they borrowed the money. And people on fixed incomes, like retirees, also tend to be hurt by inflation because their incomes don’t keep up with the rising cost of living.
Inflation can have a particularly negative impact on the poor because they often don’t have the same access to assets that the rich do. They also tend to have a higher percentage of their income going towards essential expenses, like food and housing. This means that they have less money left over to save or invest. And when inflation increases, the prices of essential goods and services go up, which can make it even harder for the poor to make ends meet.
How Governments Tackle Inflation
There are a few different ways that governments can tackle inflation. Here are 3 major strategies employed;
1 Monetary Policies
This involves the central bank changing interest rates in order to influence inflation. For example, if inflation is high, the central bank may raise interest rates in order to discourage spending and reduce demand.
2 Fiscal Policies
This involves the government changing taxes and spending in order to influence inflation. For example, if inflation is high, the government may increase taxes in order to reduce demand.
3 Supply-Side Policies
This involves the government changing policies in order to increase the supply of goods and services. For example, if there is a shortage of housing, the government may relax zoning laws in order to encourage more construction.
Effects Of Inflation On The Currency Market
Now that we’ve looked at some of the major drivers of inflation, let’s take a look at how it can affect the currency market. Inflation can have a significant impact on currency values because it leads to changes in interest rates. And when interest rates change, that often leads to changes in the value of a currency.
For example, let’s say that inflation is high in the United States but low in Europe. This would lead to higher interest rates in the United States and lower interest rates in Europe. And this, in turn, would lead to an appreciation of the dollar and a depreciation of the euro.
Inflation can also affect currency values by influencing a country’s trade balance. For example, if inflation is high in a country, that country’s exports will become more expensive for other countries to buy. This can lead to a decrease in demand for the country’s exports and a trade deficit.
Overall, inflation can have a significant impact on currency values. And while it’s not the only factor that influences exchange rates, it’s certainly one of the most important.
3 Ways To Protect Yourself From The Effects Of Inflation
1. Invest In Assets That Increase In Value With Inflation.
This includes things like property, stocks, and bonds. One way to do this is to invest in inflation-protected securities, like TIPS in the United States.
2. Diversify Your Portfolio
This means investing in a variety of different assets, including both stocks and bonds. This will help to protect you from the effects of inflation because not all assets will increase in value at the same rate.
3. Have An Emergency Fund
This is important because it will give you a cushion to fall back on if the cost of living goes up unexpectedly. It’s a good idea to have enough money saved up to cover 3-6 months’ worth of expenses.
The Consequences Of High Levels Of Inflation
High inflation can have a number of negative consequences for an economy. Here are 3 of them;
1. It Can Lead To Higher Interest Rates.
This is because high inflation often leads to higher interest rates. And when interest rates are high, that can discourage spending and investment. Governments may also raise taxes in order to try to control inflation.
2. It Can Reduce The Purchasing Power Of People’s Incomes.
This is because when prices are rising, people’s incomes don’t go as far. So, they may not be able to afford as much as they could before.
3. It Can Lead To A Decrease In The Value Of The Currency.
This is because high inflation often leads to higher interest rates. And when interest rates are high, that often leads to a depreciation of the currency.
How Does Inflation Affect Your Trading Strategies?
As a trader, it’s important to be aware of the effects of inflation on the markets. Inflation can have a major impact on currency values, interest rates, and commodity prices. And all of these things can affect your trading strategies.
If you’re trading in the Forex market, for example, you need to be aware of how inflation can influence exchange rates. If you’re trading commodities, you need to be aware of how inflation can affect commodity prices. And if you’re trading stocks, you need to be aware of how inflation can affect interest rates.
Another way to protect yourself from the effects of inflation is to diversify your portfolio. This means investing in a variety of different assets, including both stocks and bonds. This will help to protect you from the effects of inflation because not all assets will increase in value at the same rate. Additionally, you can consider reducing your risk per trade in times of uncertainty. If you are trading the spot market, you can reduce your lot sizes. If you are trading futures contracts them you can decide to be conservative with how much of your capital you allocate to certain assets in times of inflation.
Inflation can have a major impact on the markets. And as a trader, it’s important to be aware of how it can affect your trading strategies. By being aware of the effects of inflation and by diversifying your portfolio, you can help to protect yourself from its negative consequences.