Inflation’s Effect on the Economy and Your Life

Inflation’s Effect on the Economy and Your Life

Inflation's Effect on the Economy and Your Life
Reading Time: 5 mins

One of the most familiar terms in economics is a concept not many people understand, yet we all experience and feel its effects—inflation. If inflation is occurring, leading to higher prices for basic necessities such as food, it can have a negative impact on society at large. But it’s not always a bad thing.

Understanding How Inflation Impacts You

Inflation is the reason that $100 in 1980 could buy goods or services that cost $330.38 in 2021. In the past 41 years, Canada has experienced a cumulative inflation rate of 230 percent. This means that the Canadian dollar had substantially more purchasing power in 1980 than it has today. You can believe older people so say that they once drove home with a brand-new F-Series Ford for just $8,000.

Although people usually regard inflation as a negative, it can spark economic growth when limited to certain percentages. Governments often recommend a core rate of inflation in order to catalyze economic growth. For instance, in 1991, the Canadian government asked the Bank of Canada to create a stable inflation rate of about 2 percent and to maintain the rate between 1 percent and 3 percent to encourage growth.

Understanding how inflation affects economic growth is crucial if you want to budget for your future or invest in the Canadian market. In this article, the experts at MoneyWizard.ca analyze the effects of inflation on the economy, financial markets, and the average Canadian. Click through to understand what you need to know about inflation.

What Is Inflation?

Inflation is a general rise in the prices of goods and services over a given period, like a month or year. The rising prices of consumer goods and services devalue a nation’s currency, reducing its purchasing power. The inflation rate is a quantitative estimate of the rate of decline in the purchasing power of a currency.

Like a national economy, the global economy also experiences inflation. As of 2020, the global inflation rate was estimated to be about 3.18 percent. In the same year, Canada reported an inflation rate of 0.72 percent. This means that, on average, the prices of the representative goods and services increased by 0.72 percent over the course of the previous year. The ‘representative’ basket of goods and services consists of typical goods and services used by the average Canadian.

The Consumer Price Index, a measure of the average prices of these goods and services, is used to calculate the inflation rate of a country. In June 1920, Canada reported a record-high inflation rate of 21.60 percent. A year later, in June 1921, the inflation rate had dropped to an all-time low of negative 17.80 percent. Other countries have seen worse. Today, Zimbabwe struggles with an inflation rate in excess of 600 percent. Venezuela has suffered hyperinflation of 6,500 percent.

As determined by relative severity, inflations are categorized into four types.

1. Creeping Inflation

Creeping inflation is mild inflation of about 3 percent or less. According to many economists, inflation of about 2 percent stokes economic growth. This is so because people will buy goods and services for fear of future price rises, which is good for the economy.

2. Walking Inflation

Walking inflation is inflation between 3 percent and 10 percent. Walking inflation leads people to buy more than they need to beat future prices, helping to increase prices to unbearable levels.

3. Galloping Inflation

Galloping inflation is inflation above 10 percent. This amount of inflation fosters economic chaos. Investors shy away from investing for fear of the high cost of doing business. Galloping inflation can be catastrophic if not immediately and effectively suppressed.

4. Hyperinflation

If a country fails to contain galloping inflation, the result is likely to be hyperinflation, a general increase in the prices of goods and services of more than 50 percent a month. Hyperinflation frequently leads to the collapse of a nation’s economy. Today, Zimbabwe and Venezuela are experiencing hyperinflations that are among the worst in human history.

What Causes Inflation?

Several factors cause of inflation in global markets and in Canada.

1. Supply and Demand

Increasing demand for goods and services is a major cause of inflation. Increased demand causes demand-pull inflation; it occurs when the demand for goods and services exceeds the supply. At this point, consumers pay more than the previous retail prices, further inflating the costs of goods. Cost-push inflation, a less common scenario, occurs when the supply of goods and services is restricted as demand remains constant. The reduced supply causes the cost of products to rise.

2. Money in Circulation

An increase in the amount of money in circulation does not directly cause inflation. But when there is too much money in people’s hands chasing too few goods, the prices of the goods will rise significantly due to either demand-pull inflation or cost-push inflation.

3. Expectation of Future Inflation

Expectation of future inflation often motivates people to buy more goods and services in an attempt to beat the high prices of tomorrow. This increased demand for goods and services will lead to what is called “built-in” inflation.

Why You Should Care about Inflation

Everyone feels the pinch when inflation strikes. As inflation devalues currencies, you pay more money for the same amount of goods, and this must concern you. But some persons suffer more from the effects of inflation than others do. For example, inflation can mess up your retirement plans big-time. If you are saving for retirement pre-inflation, you should adjust your contributions to factor in the effects of inflation. The amount of money you saved for retirement before inflation will not now be sufficient to provide you with the same quality of life.

Individuals holding fixed-income assets are also hit harder by inflation. Assets like bonds and Treasury notes pay fixed benefits regardless of inflation, so a high rate of inflation necessarily dilutes the value of these investments.

In the case of a hyperinflation and total economic collapse, your money will lose at least 50 percent of its value. The decline will probably accelerate until the hyperinflation can be stopped. It takes a long time for a country to recover from a hyperinflation.

How Inflation Affects You

Inflation can make you or it can break you, depending on your financial position before it kicked in. You can make insane profits if inflation increases the prices of your real estate. The same goes for stock and any other assets that you acquired at relatively lower prices before inflation boosts their prices.

In general, though, inflation decreases your purchasing power. When the prices of goods and services increase, you can’t buy as much as you could before the advent of the inflation. The cost of living goes up, and you probably won’t be able to afford the same quality of life.

Inflation does not affect everybody in the same way. The prices of real estate may rise in a sustained way as the prices of everything else, like gasoline and groceries, remain more or less the same. So a person who doesn’t drive to work and has no plans to buy real estate won’t feel the burden of inflation the way someone who drives a guzzler and is buying a home will feel it.

What You Should Do in an Inflationary Environment

The experts at MoneyWizard.ca observe that inflation does not affect every sector of the economy with the same intensity. It is impossible to completely escape the effects of inflation, but shrewd investment practices can reduce the damage you suffer. Invest in sectors that benefit from inflation and stay away from the sectors that take direct hits.

Money markets are a safe investment if you want to preserve the value of your money during inflation; the rates in this sector are adjusted when inflation hits. Your investment remains fluid throughout the inflation period, preventing serious financial losses.

Also consider real estate, a sector that is often resilient during an inflationary period. One reason is that as the cost of rentals increase, people increasingly see the value of owning homes. But although real estate is a relatively safe investment, it is not safe when a real estate bubble is looming.

Other ways to protect yourself from inflation include ditching long-term fixed-income investments, investing in the commodities market like precious metals and oils, and adopting fixed-rate debt instead of adjustable-rate debt.

Plan for Inflation

Protect your investments from inflation by adopting smart approaches to investment. Buying a home can help you avoid paying exorbitant rent when inflation rages. Stocks can also be a good investment during inflation. But avoid debt the interest rate of which is adjusted with inflation. Such safe practices can help you plan your financial future during and after an inflation.

Conclusion

Since the effects of inflations are felt throughout the economy, never assume that news about inflation does not concern you. Engage in safe investment practices that will cushion you from the impacts of inflation. Make sure that whatever investments you are considering will protect the value of your assets and finances in the long run.

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