Inflation is a rise, over time, of the price of goods and services. This rise in price alone does not entirely define inflation. To quantify inflation, there must also be a decrease in the value of currency. In other words, money does not buy as many goods and services as it used to; generally defined as an erosion of purchasing power.
The base measure of inflation, in economic terms, is the annual percentage change in the Consumer Price Index over time. The Consumer Price Index is a statistically calculated measure of the cost of goods household consumers normally purchase on a regular basis.
What Causes Inflation?
There are some schools of thought that believe excess printing of money can lead to inflation. Monetarists believe the single most important factor causing inflation is the rapid decrease or increase of money. They follow the quantity theory of money, which states any change in the amount of money available will affect the price of goods and services.
The alternate school of thought regarding inflation is the quantity of money is only a small factor in relation to inflation. Keynesian economists believe there are several causes, or an aggregate group of causes, that lead to inflation. There are three basic models of inflation set forth by Keynesian economists; demand-pull, cost-push and built-in inflation.
- Demand-pull inflation is caused by an increase in demand due to increased government and private spending; this type of inflation is generally beneficial to the overall economy.
- Cost-push inflation is generally a result of natural disasters or increase pricing of component supplies for manufacturing, usually significant, drop is aggregate supplies.
- Built-in inflation is generally a result of workers trying to maintain wages in excess of costs, with businesses passing along higher wage costs to consumers of end products and services.
How Inflation Hurts Us (especially the poor).
Unpredictable inflation rates can adversely affect the overall economy of a country through uncertainty in the future economic health of the country and a reduction in the ability to save and invest money.
Along with causing consumer monetary difficulties, unpredictable inflation rates can cause businesses to avoid budgeting or long-term investing. Many businesses, in times of high inflation rates, may be required to transfer resources away from production and manufacturing to focus on profits and cover losses.
Another extremely negative effect of inflation is the potential for what is known as a wage spiral. This is a serious of events during which workers demand an increase in pay to keep up with inflation, which in turn causes the cost of goods to increase. The cost increase for goods leads to another demand for wage increases. And so, the cycle can continue into a state of hyperinflation.
One additional effect of inflation is the desirability to maintain high balances in high-yield, or high interest, bank accounts. Even with the largest majority of a business’ cash assets in a high interest bank account, cash is still necessary to complete transactions for purchases and costs of goods sold. This may cause a need to continually withdraw money from the bank and can lead to high penalty and transaction charges.
How to Hedge Against Inflation.
One method for setting an investment amount aside in the event of inflation, or even hyperinflation, is to invest in precious metals such as gold and silver. Precious metal pricing is still set by a fluctuating market; however, in recent years gold has increased in value exponentially compared to its price per ounce just a few decades ago.
Tangible assets in precious metals are not as susceptible to fluctuating paper currency values and have traditionally been a safe investment.
One government issued insurance for investors against inflation is the Treasury Inflation-Protected Security. These bonds are issued by the United States Treasury department and are indexed to account for inflation over a calculated period of time. The principal of the bond is determined by the Consumer Price Index, which is the calculated measure of inflation.
These are the two most common methods of preparing/hedging against inflation. To learn more about inflation and inflation hedging, check out Inflation, which explains the rest of how inflation is created, how it hurts us, and how to prepare for it.
The interest for the security fluctuates when it is multiplied against the adjusted principal amount of the bond. The principal amount will never change, with this type of bond currently available in five, ten and thirty-year maturity notes.