What is Inflation?
Inflation is a topic used in economics and other related fields. It describes the decline of the purchasing power of a given currency over time. Practically, most currencies around the world suffer inflation after a specific period of time. However, some currencies may also experience an increase in purchasing power, known as deflation.
It is possible to quantify inflation. The process begins with the selection of a basket of goods and services. After that, the process involves calculating the rate at which the purchasing power of the currency has declined using the given basket as a base. This calculation allows users to obtain an inflation index, which provides a basis to calculate the fluctuation in purchasing power over time.
While, seemingly, inflation is a bad thing, there is still debate around the topic. Sometimes, inflation can even be good for the economy of a country.
How is Inflation a good thing?
Inflation can be good as it allows businesses to increase their profits over time. Similarly, it helps them prevent their consumers from waiting for lower prices before making a purchase. In fact, some experts believe that the primary function of inflation is to prevent the deflation of a given currency. Besides these, there are also several other benefits of inflation.
In theory, inflation can help increase production when an economy is not running at capacity. When consumers pay more for the products that cost less before, it means they are spending more. In economics, more spending results in an increase in demand for products or services. Consequently, the increased demand for goods and services boost production to meet that demand.
Similarly, theoretically, deflation can deteriorate a given economy. When customers expect their purchasing power to increase or the currency to deflate, they hold off on purchases to wait for better prices. It causes the opposite reaction caused by inflation, as the lower spending translates into lower demand and, subsequently, lower production.
Inflation can also be useful for businesses. Any company that makes credit purchases pays less for the goods due to inflation. This concept relates to the time value of money. When a business makes a credit purchase, the products or services may be worth higher. Subsequently, due to inflation, it pays the same amount of money but with lower purchasing power.
How can Inflation affect investments?
While inflation may be good for the economy, it can also pose a threat to investors. It is usually because it decreases investor’s investment returns. While investing, most investors aim to increase their long-term purchasing power. However, due to inflation, this goal may be at risk because they need to make investments that can keep up with inflation and increase the investors’ purchasing power at the same time.
When investors don’t consider the effect of inflation on their portfolios, it may harm them. Especially for investors that have fixed-income securities, inflation can cause a negative impact. It is because these fixed-income securities come with a fixed interest rate. If the interest rate falls below the inflation rate, it can result in negative returns.
Inflation is a concept that refers to the decrease in the purchasing power of a currency. For the economy, inflation is a good thing as it increases demand and supply. However, for investors, inflation may be problematic. Therefore, investors need to keep an eye on their portfolio to protect against its negative effects.