It’s impossible to read the financial section of any news publication these days without bumping into the scary term – Inflation. Most of us know that allegedly inflation is bad, but is that true? And if so, why is it bad? That is what we are going to explain in this article. It’s actually very simple once you understand the basics.
If you can’t be bothered to read on and want the bottom line right now, we’ll give it to you. Inflation by definition is the continuous increase in price for goods and services the households consume, and that is a bad thing. There, that’s inflation for you in a nutshell, however, presumably you already knew that and you’re here to learn about the bigger picture. So read on.
Once inflation starts rising, each unit of currency will buy you less and less. Thus, the purchasing power of your money decreases as the inflation increases.
Therefore each country has a different range in which it attempts to keep the inflation. This range is usually somewhere between 1%- 6%. However the exact rate varies between countries.
Why though is this bad? Other than the fact that that 100$ will no longer be enough to buy you a newspaper? To fully understand, we need to examine the bigger picture. There are many problems and dangers that come with inflation.
Shoe leather cost
Once inflation begins to increase rapidly, people will begin to attempt to protect their money. People will run around from one bank to another trying desperately to protect their cash. Also, since a loaf of bread will now cost you a million dollars, you will need to make a significantly lager number of trips to the ATM. Hence the name. All this running about inflicts wear and tear on the shoes. Since everyone is spending far more time running about, this also means that time that would normally be used to manufacture and produce is now wasted. So the country as a whole is now producing less product. This is bad for everyone.
When inflation is soaring, another issues is the menu cost. Imagine a restaurant with two employees. Two waiters. Under normal circumstances both waiters would be serving customers. However with the increased inflation this means that the prices on the menu need to be increased on a daily basis. Thus, one waiter will spend all day updating the prices on the menu. This means the restaurants effective staff has decreased by half. Only on waiter is now free to serve customers. This also happens in the super market, in the coffee shop, in the hardware store and every other business out there. Add this all up and you have a massive amount of people working but not producing any products or providing services.
Increasing the gap between the rich and the poor
This doesn’t need much explanation. Once inflation begins to skyrocket out of control, there will always be better ways and worse ways to protect your money. Who is going to loss more of their money? The poor that haven’t good much financial education? Or the rich that can afford to hire the best lawyers, accountants and advisers? Exactly. The rich will alway be better off. They will lose less and the social gap increases.
Uncertainty hurts new ventures
Under normal circumstances, if an entrepreneur is considering a new venture, he will sit down and calculate the expected return on the investment. After the calculations are complete, a decision can be made as to whether the venture is worth while or not. Once inflation is out of control, it becomes damn near impossible to calculate what will happen tomorrow yet alone a year or two down the road. This uncertainty means that since the potential risks can’t be assessed, most entrepreneurs prefer to play it safe and not invest at all. This hurts the economy hugely as potential jobs are lots, potential tax revenue won’t be collected and so much more.
So what’s the bottom line?
This all seems awful, so you may be asking yourself, if inflation is bad, is deflation a good thing? Deflation being of course the opposite of inflation. Thus the continuous decrease in the price of services and goods consumed by households. Actually, this is just as bad as inflation. Why? If prices are decreasing, it means demand for products is on a decline. Once demand for products are on a decline, manufacturers produce less and therefore have no choice but to eventually lay off employees. These freshly layer off employees now have no income and decrease their spending habits. This pushes overall market demand down even further, meaning that more employees will be fired and it’s a never ending snowball.
So what need to be done? Inflation needs to be kept in a safe range. This range is usually between 1%-6% as stated above. The exact rate varies depending on the country.
So that’s inflation for you. Hopefully you will now understand what the financial section of the news is on about. Of course there are many more issues that we didn’t cover, but this is a basic summary of the topic.
Photo credit: ZeroOne @flickr