Inflation - Your money's worst enemy

What is Inflation?

The economic concept of inflation can be defined as the devaluation of the currency that causes a rise in the general level of prices of goods and services in an economy over a period of time.
The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.

When the currency devaluates, the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy (the currency).

With the prices rising, a currency bill buys less each year; in other words, when inflation is present, your money is worth less and less...

The magnitude of inflation - the inflation rate - is usually reported as the annualized percentage growth of some broad index of money prices.

United States historical inflation rate

How Inflation works?

Increases in the quantity of money or in the overall money supply (or debasement of the means of exchange) have occurred in many different societies throughout history, changing with different forms of money used.

For instance, when gold was used as currency (see The Gold Standard - Money versus Currency), the government could collect gold coins, melt them down, mix them with other metals such as silver, copper or lead, and reissue them at the same nominal value. By doing this, the government could issue more coins without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the consequence is inflation.

This practice would increase the money supply but at the same time the relative value of each coin would be lowered. As the relative value of the coins becomes less, consumers would need to give more coins in exchange for the same goods and services as before. These goods and services would experience a price increase as the value of each coin is reduced.

The adoption of fiat currency (paper money) (see The Gold Standard - Money versus Currency) by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have taken place in a number of countries, producing hyperinflations - episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money. The hyperinflation suffered by the Weimar Republic of Germany is a notable example.

How you are affected by inflation?

It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income.

Your investments could be seriously affected by the inflation (see How inflation erodes your investments). Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. For example a saver might receive a 3% nominal rate of interest on his deposit account, but if the annual rate of inflation is 5%, then the real rate of interest on savings is -2%.

In conclusion

Inflation is entirely and only due to an increase in the money supply in the economy and the prices will rise as an inevitable consequence of inflation.

The main consequences of high inflation are:

• Increase in the cost of living;
  
• Low levels of domestic and foreign investments due to the economic and political instability;
  
• Savings will be discouraged since the real value of savings declines;
  
• Long-term investments will be discouraged;
  
• Real wages fall sharply;