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Inflation 101: What it is, how it affects you
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We hear about inflation all the time, and a lot of the things that directly affect us, like mortgage interest rates, purchasing power, investments and our bank accounts are influenced by it, so what exactly is inflation and how does it play such a big role in our economy?
Inflation, in its most basic definition, is a rise in the general level of prices of goods and services in an economy over a period of time. As prices rise, each unit of currency has less purchasing power, because it can’t buy as much.
One might assume that an ideal economy is one which presents as little unemployment as possible. The big surprise is that when there are fewer people who are looking for work, employers have to try harder to recruit and have to pay them more, therefore low unemployment and rising wages contribute to (rising prices) inflation.
In times of low unemployment, more people are working, therefore have more money to buy things, and as we know from basic economics, there are limited resources. When the demand of consumers is greater than the amount companies can produce to meet this demand, prices go up until the supply and demand is more closely aligned. Remember that in inflationary times, goods and services cost more, and money doesn’t buy as much. Increasing the money supply causes inflation, and this also includes the government printing money faster than the growth of real output.
How to fight inflation
When there are signs that inflation is looming, the government usually raises interest rates, in an attempt to slow down peoples purchases, allowing supply to catch up to demand. The side effect of raising interest rates is that companies have to pay more to borrow, and therefore the increased borrowing rates reduce their profitability. Investors begin to think twice about buying stock of companies showing decline in profits. High interest rates also cause higher yields on bonds, thus people tend to start looking into bonds rather than stocks, which causes the stock market to drop. There are many variables which cause inflation, and once it starts to rise, it affects many different areas of the economy.
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