5 Things you NEED to know about Inflation, the falling dollar and Purchasing Power
Inflation is both terrifying and very hard for the average person to understand. Most of us realize that it is a bad thing, but not exactly why it is bad or how it will affect us and our families. My goal in this article is to explain, as simply as possible, exactly what inflation is, how it affects us normal people and how you can protect yourself from it. I was going to try and cram all of this into one article but realized that it would be REALLY long...so I have broken it up into a series... ENJOY!!!
Defining Inflation - Inflation is actually a very basic concept, it is simply a decrease in the purchasing power of a currency. That is it. To that end, the inflation rate is just the PERCENTAGE of the decrease in purchasing power. So if the inflation rate is 2% then, you are able to buy 2% less stuff with your money then you were last year OR that the stuff you buy costs 2% more, which is the same thing, just a different way of looking at it. Deflation is the opposite of inflation, it means that the price of stuff is falling and you are able to buy MORE for the same amount of money, so your money is worth MORE relatively. Over the long run it is inflation that we really need to be concerned with even though there have been periods of deflation throughout history, usually corresponding with recessions or depressions, for most of us, being able to buy MORE is a good thing.
1. Inflation is an "invisible tax"
Yep, that is correct, inflation is a tax. Though my training is in economics, I am going to try and keep this really basic and easy to understand. Inflation is caused when there is more money chasing fewer goods. There are only two ways that this situation can happen. #1 There is a shortage of goods for some reason (think a really hot toy at Christmas or a super popular car, or real estate a few years ago) since there is a shortage of the particular good that people are after, the price of that good goes up. This is the basic law of supply and demand; the price will increase until the demand finally decreases or until there is more supply. We saw this happen with oil. When the economy was good, there was so much demand for oil that the price kept increasing. When the economy imploded, so did the demand for oil and, consequently, the price of oil. Now supply issues also affected the price of oil, but all else being equal, the huge run-up in price and subsequent decrease in price corresponded with the state of the economy and the demand for the product and not with the underlying supply constraints. The exact opposite happened with oil in the 1970s when OPEC limited the SUPPLY of oil which caused the price of oil to skyrocket.
The second way for inflation to occur is when the actual supply of money in the economy increases. Imagine an economy for a make-believe country that only produces 100 potatoes per year and all of those potatoes are consumed or used every year. That is their entire economy, 100 potatos. This economy also has a money supply of exactly 100 dollars. At the most basic level the value of a country’s currency is going to be the total VALUE of the country’s economy divided by the total money supply of that country. Now we are really simplifying things to make a point but you get the idea. So then what is the value of 1 potato? Easy right, it is 100P/ $100 = $1. Ok, now imagine that the government of our fictional country decides to print another $100, so now the money supply is $200. Now what is the value of 1 Potato? It is 100P/ $200 =$2. So the price of the potato just doubled...now this is great if you own potatoes as they are now worth twice as much money as they used to be...however, if you are a consumer who is buying potatoes, things just got much worse for you as the PURCHASING POWER of your money just got cut by 50%.
I mentioned above that inflation is actually a tax....can you see why this is so? Who created the extra $100? That is right; it was the government of the country. When a Government creates money they are able to spend or lend that money in the exact same way they would spend tax money they had collected. So instead of collecting $100 in taxes our fictional country's government decided that they could achieve the same thing by just printing the money instead. This is usually much easier politically as instead of raising everyone’s taxes, which most people oppose, they just print the amount of money they need and let the subsequent rise in prices across the economy take care of the rest. They have not taken your money...they have just taken the VALUE of your money by the exact percentage by which they have increased the supply of money in the economy. If the Government prints 1% more money, then your money is worth 1% less in terms of its purchasing ability. Pretty neat trick huh?
Now, I have really simplified the process in order to make a point. The reason that this little trick works so well is that, in the real world, it is far more convoluted and complex and therefore much harder to detect and understand.
Stay tuned for my Second hub in this series "Your money really is just paper....at least these days."
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