Inflation is an integral part of the modern market economy. Many investors have heard about inflation, but few can define inflation, explain its causes and how it affects the liquidation value of an investment portfolio.
Inflation is the increase in prices of products and services over time. At the same time, some products and services may go up more quickly, the second – more slowly, and still others – do not change in price or become cheaper. The opposite process, when prices of products and services go down, is called deflation.
Inflation and purchasing power of money
Inflation destroys the purchasing power of money over time. Tomorrow it will be possible to buy less goods and services for the same amount of money than today. Inflation depreciates money according to the rule of compound interest. Let us consider how the purchasing power of the US dollar decreases with time, with an average annual inflation rate of 3%. The graph shows how inflation destroys more than 80% of the purchasing power of the US dollar in 53 years:
Causes of inflation
Inflation occurs for many causes, the main of which are listed below. All causes are interrelated: one cause gives rise to the second, the second to the third, and so on. Because all causes are part of a single market economy:
- Increased demand. When people start buying more goods and services, they increase demand. Increased demand always leads to higher prices. With increased demand, sellers do not make sense to leave prices at the same level, they increase them, increasing own profits. This happens when new marketable products are brought to the market that have not yet managed to satisfy the market, or when consumers expect products to become a deficit in the future;
- Decreased supply. Goods and services may become scarce not only with an increase in demand, but also with a decrease in supply. When demand remains at the same level, and the level of supply of goods and services decreases, prices begin to rise. Production may fall due to natural disasters, collusion of monopolists, economic sanctions, hostilities, etc.
- The weakening of the national currency of the importing country. With the fall of the national currency against foreign currencies, prices for imported products increase. When individual industries or the whole economy depend on imports, this makes the importing country dependent on the exchange rate of the foreign currencies of the exporting countries. The opposite is also true when a country is an exporter and its national currency becomes more expensive;
- Additional issue of money. Many countries print extra money. When the amount of money in circulation increases faster than the quantity of goods and services that can be bought with this money, this provokes a rise in prices. The more banknotes, the less the purchasing power of each of them. Thus, the government taxes the owners of money;
- Rising energy prices. The global economy depends on the price of oil and gas. In order to deliver goods or services from manufacturers to sellers, and from sellers to end consumers, land, sea or air transport is required. This transport requires fuel produced from oil or gas. When the prices of oil and gas rise, this growth is laid by producers in the price of goods and services, shifting the increased costs to end consumers;
- Salary growth of employees. Competition among employers allows employees to demand higher wages for their work, or to change jobs, leaving for another employer. This forces employers to make concessions and raise wages so that the employee does not go to a competitor. Higher salary costs are reflected in higher prices for final products and services.
Methods for calculating the rate of inflation
There are many methods for calculating the rate of inflation. The most popular are:
- Consumer Price Index (CPI) – based on the price level of various goods and services of the consumer basket. About 500 goods and services, which are used by the average consumer, are taken and the index is calculated on the basis of the prices of these goods. It is the most popular way to measure inflation;
- Producer Price Index (PPI) – based on the price level of various industrial goods, such as raw materials, semi-finished products, components, materials and finished products. Outperforms the consumer price index because industrial prices are rising faster than consumer prices;
- Asset price index (API) – based on the price level of various financial and tangible assets, such as stocks, bonds, real estate, loan capital, etc. It outpaces the CPI because asset prices rise faster than consumer prices and services.
The positive impact of inflation on the economy
With all the destructive properties of inflation, it can have a positive impact on economic development. Provided that the inflation rate does not exceed 4–5% per year:
- Stimulates the turnover. Consumers, knowing that over time the prices of goods and services are rising, try to buy today, not postponing purchases for tomorrow;
- Lowers unemployment. The constant rise in prices stimulates people to develop professionally, to work more in the current place of work or to look for a new place of work, more promising and highly paid;
- Acts as natural selection. Inflation is ruining economically weak enterprises that produce noncompetitive products. Free markets occupy more economically healthy and efficient enterprises;
- Makes people invest. Money under the mattress does not participate in the economy and depreciates. If you invest in promising industries, the money will work, bring benefits to the industry and the income will be higher than inflation. If the wealthy people do not invest, inflation will eventually destroy all their capital. If the poor people – they can not get wealthy.
Inflation is a natural process in a free market economy, a consequence of the balance of supply and demand. If the prices are forcibly fixed, this will lead to an imbalance of supply and demand, poor quality and scarce goods and services. On the one hand, inflation destroys the purchasing power of money by raising prices, on the other hand, it stimulates economic development.
Investors should be wary of high inflation when it exceeds 8–10% per year. At such rates, it is required to be very selective in choosing assets for investment so that they have a return higher than the inflation rate and have an adequate level of risk.
With lower rates of inflation, it is fairly easy and simple to form an investment portfolio whose liquidation value will outperforms the rate of inflation, increasing the purchasing power of capital.