In the previous articles, we have discussed the trickiness of human needs, the value of time, we defined our main values, and set happiness as the ultimate goal. The topic of this and the following two articles pay to the social-economic reasons for investing. Thus, we go through some of the common incentives and pitfalls of our economic system.
What is inflation
Borrowing a definition from Investopedia, ‚inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency.‘
In the layman terms, the inflation rate tells you, how fast your money is losing its value.
Most of you have probably heard some older people nostalgically remember how everything was cheaper in the past. Golden times, we were doing better, they say. Of course, it depends on the country and time, but in most cases, if you compare the current prices and salaries with the historical data, you prove them wrong. Now, let’s forget the incomes and focus on inflation only.
For example, let’s say we had 1 000 € since the beginning of 2018 until the end of the year. The average inflation for Europe in 2018 was 1,52 %. On January 1st, we were shopping and paid for exactly 1 000 €. By the end of the year, the same purchase – precisely the same list of products – would have cost us approximately 1 015,2 €, if averaged among all the stores around. Even though we still had the same nominal value of cash in hand, the prices increased. So over time, we can buy less and less with a constant amount of money.
The real power over time
Have a look at another case, in the longer term, just to fully understand the consequences. The inflation rate in the eurozone between 1998 and 2018 was 40.63%, which translates into a total increase of 406,28 €. This means that 1 000 € in 1998 are equivalent to 1 406,28 € in 2018, see the chart below. The average annual inflation rate between these periods (over 20 years) was only 1,72% and we have already lost over 40 % value of our money. You can check it on your own in this calculator.
Now imagine, if the annual inflation rate was 3,53 %, then the real value of our savings would have shrunk by half. Keep in mind that 20 years is not so long time at the current level of life expectancy. It can happen to you a few times.
Another example from abroad, the US dollar has lost over 96 % of its value since 1913, the year the government started with these statistics. If you think it’s different in Europe, look at the statistics. The current rate is about 1,6 %, but since 1997, we have seen a range of -0,5 % up to 8,4 %. Some countries suffered even worse. Iceland experienced the inflation rates of 21 % in 2008, resp. 11,3 % in 2009, just before the economy collapsed.
It should be mentioned that inflation is not always bad. If you have a loan or repay a mortgage, inflation works in your favor. The real interest rate you pay is reduced by the inflation rate each year. That’s not a good reason for borrowing though.
Causes of inflation
So, what causes inflation? There are several situations:
- Rising costs of production push the wages higher which increases the pressure on prices. A very low level of unemployment is one of the factors because it increases the labor costs of production.
- Tax cuts allow businesses to invest in themselves, and citizens to spend them. The demand for goods and services is increasing which leads to price growth.
- Devaluation of the currency causes the domestic goods are cheaper so either local and foreign buyers increase the demand and push the prices higher.
- Quantitative easing, or more aptly, money printing by the central banks allows them to buy government securities to encourage lending and investment.