Saturday, 8 February 2014

Inflation Explained

What's Inflation?
Inflation is divided into two types: Price Inflation and Monetary Inflation, the first type (about prices) is when there is a rise in the general level of prices of goods and services over a period of time, the second type (monetary) is when there is a rise in the quantity of money in an economy. Both types are in many times interrelated, and both have negative effects on the economy and individuals.

Effects of Inflation
Most effects of inflation are negative, and can hurt individuals and companies alike, below is a list of "negative" and “positive” effects of inflation:

Negative effects are:
- Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortages of the hoarded objects).

- Distortion of relative prices (usually the prices of goods go higher, especially the prices of commodities).

- Increased risk - Higher uncertainties (uncertainties in business always exist, but with inflation risks are very high, because of the instability of prices).

- Income diffusion effect (which is basically an operation of income redistribution).

- Existing creditors will be hurt (because the value of the money they will receive from their borrowers later will be lower than the money they gave before).

- Fixed income recipients will be hurt (because while inflation increases, their income doesn’t increase, and therefore their income will have less value over time).

- Increased consumption ratio at the early stages of inflation (people will be consuming more because money is more abundant and its value is not lowered yet).

- Lowers national saving (when there is a high inflation, saving money would mean watching your cash decrease in value day after day, so people tend to spend the cash on something else).

- Illusions of making profits (companies will think they were making profits while in reality they’re losing money if they don’t take into consideration the inflation rate when calculating profits).

- Causes an increase in tax bracket (people will be taxed a higher percentage if their income increases following an inflation increase).

- Causes mal-investment (in inflation times, the data given about an investment is often deceptive and unreliable, therefore causing losses in investments).

- Causes business cycles (many companies will have to go out of business because of the losses they incurred from inflation and its effects).

- Currency debasement (which lowers the value of a currency, and sometimes cause a new currency to be born)

- Rising prices of imports (if the currency is debased, then it’s purchasing power in the international market is lower).

"Positive" effects of inflation are:
- It can benefit the inflators (those responsible for the inflation)

- It be benefit early and first recipients of the inflated money (because the negative effects of inflation are not there yet).

- It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause price control set by the cartels for their own benefits).

- It might relatively benefit borrowers who will have to pay the same amount of money they borrowed (+ fixed interests), but the inflation could be higher than the interests, therefore they will be paying less money back. (example, you borrowed $1000 in 2005 with a 5% fixed interest rate and you paid it back in full in 2007, let’s suppose the inflation rate for 2005, 2006 and 2007 has been 15%, you were charged %5 of interests, but in reality, you were earning %10 of interests, because 15% (inflation rate) – 5% (interests) = %10 profit, which means you have paid only 70% of the real value in the 3 years.

Note: Banks are aware of this problem, and when inflation rises, their interest rates might rise as well. So don't take out loans based on this information.

- Many economists favor a low steady rate of inflation, low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

- Tobin effect argues that: a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects.

The first three effects are only positive to a few elite, and therefore might not be considered positive by the general public.

How to Survive Inflation?
Tips to avoid the negative effects of inflation are only suggestions and don’t constitute any legal advice, therefore you’re free to use your own judgment depending on circumstances, to be more prepared to face inflation effects you need to be aware of those effects, so if you haven’t done so, please read some of them above, here are some tips:
- Be wise when holding cash, whether in your home or in your savings account, if you’re earning 5% interest on the money you have in your bank, and inflation rate is 10% then you’re in reality losing 5% and not earning anything.

- Be careful when buying bonds, high inflation rates completely destroy the value of long-term bonds.

- If you have a variable-rate mortgage, fix it if you can find a good deal, have a low fixed interest rate or 0% interest if you can find one.

- Invest in durable goods or commodities rather than in money. Check out our commodities list.

- Invest in things that you're going to use anyway and will serve you for a long time.

- Invest for long-term capital gains, because short term investments tend to give deceptive results or sense of making profits while in reality you’re not making profits.

- Learn about bartering which is trading goods or services without the exchange of money (it was very popular in hyperinflation times).

- Manage wisely your recurring monthly bills such as (phone bills, cable TV...), it would help to reduce them or eliminate some of them.

-Same goes with ephemeral items (movies, restaurants, hotel rooms...) they’re not bad if you spend money on them in moderation.

-Ask yourself, do I really need these things I’m spending my money on? Think how much and how often you will need something before buying it.

-Use the money saving tips such as: you need to reduce your consumption of things that are rising rapidly in price (eg, gas) without having to reduce your consumption of goods that are rising less rapidly or even falling in price (eg, clothes).

-Buy only what you need, especially objects that have multi-tasks, and are considered durable goods.

The conclusion from all this is: You don’t have to live cheap, just live smart!

Money and Inflation
Money is considered a storage of value. Normally if you were to sell a car for 100 gold coins, you should be able to go back and change that money in for another car tomorrow or the next week or the next month. When money holds its value, people feel safe saving it. Inflation weakens the function of money as a storage of value, because each unit of money is worth less with the passing of time and increase of inflation, so people tend to spend money on something else which can play the role of “the storage of value”.

Other terms related to inflation are:
Deflation: a fall in the general price level.
Disinflation: a decrease in the rate of inflation.
Hyperinflation: an out-of-control inflationary spiral.
Stagflation: a combination of inflation, slow economic growth and high unemployment.
Reflation: an attempt to raise the general level of prices to counteract deflationary pressures.
Depression: a severe and prolonged recession characterized by inefficient economic productivity, high unemployment and falling price levels.