How Inflation Works

Do your parents ever tell you how back in their days, a bowl of noodles cost less than RM 2.00? Why does food cost so much more now? One word: inflation. 

Believe it or not, money can lose value. Inflation is the rate at which the value of currency falls and as a result, prices for goods and services rise.

Whilst mostly seen as a bad thing, it is almost inevitable that inflation will take place, what can be controlled is the rate of inflation.

What Is Inflation, What Causes It?

Credits to: Marco Verch

So, why are you paying RM 10.00 for your favourite noodle dish that used to cost RM 5.00 25 years ago? In simple terms, it’s because RM 10.00 today is worth only RM 5.00 25 years ago (imagined figure.) 

Currency loses value over time due to a number of reasons, mainly because a nation’s money supply exceeds economic growth.

Ultimately, there are 3 main factors to this situation occurring: –

Demand-pull Effect: This can be caused by strong consumer demand for certain products and services. When demand increases, the supply decreases and prices increase because people will be willing to pay more to obtain the limited item or service. 

Demand-pull inflation tends to happen when the economy is good and unemployment is low.  An increased supply of money leads to increased demand for goods that surpasses production capacity. 

Cost-push Effect: Cost-push inflation occurs when prices increase due to increased production costs, such as for raw materials or wages. 

In this instance, demand remains constant but supply decreases, meaning consumers shoulder the additional costs of production.

Built-in Inflation: This is based on the expectation that the current inflation rate will continue.

As the price of goods and services are expected to increase, employees will expect wages to increase accordingly to maintain a living standard. When prices increase, wages have to rise to maintain a living wage, and the cycle continues. 

Pros and Cons of Inflation

Inflation has its pros and cons, too.

Pros

Inflation is almost never good for consumers, but certain investors and companies. For example, inflation is good for people who hold non-currency assets like property and gold because you can sell at higher prices!

Investors in utility and energy companies might see stock prices increase too when prices increase. Companies can control the prices of their products should a surge in demand occur, increasing profit margins. 

Cons

As stated, goods and services will become more expensive, so consumers will suffer, especially when it comes to necessities such as housing, food, medical care etc.! On the other hand, cash, bonds and other assets denominated in currency will also devalue.

Assuming built-in inflation keeps happening, money saved today will be valued less tomorrow. This puts a dent on consumers’ purchase power and may even force certain individuals to change retirement plans. 

Deflation

Things that inflate can deflate too, that’s hardly surprising is it? When deflation occurs, the general public enjoys a higher purchasing power as prices fall. 

Deflation usually happens when money supply or financial instruments redeemable in money decreases. Alternatively, a decrease in overall demand for goods and services along with increased productivity may also cause deflation. 

As an example, technological advances may increase the efficiency of companies in manufacturing their products, lowering production costs. In turn, the saved costs are transferred to the consumers. 

However, as good as it sounds, there is a downside. Borrowers may find themselves returning money that is worth more than what they borrowed, even though the amount is technically the same.

Conclusion

Now that you understand inflation and deflation more, can you better make sense of the fluctuations of market prices, or how money is sometimes worth more than other times? 

Understanding the times we are in is hugely important to managing our finances and building wealth to overcome inflation!