First, we define inflation as the rate of increase in the value of goods and services over time. This might be regarded as influencing the value of a dollar because individuals will be able to buy fewer products with the same $1 bill today than they could previously.
Although the rate of inflation varies from year to year, from 1913 and 2013, the United States saw an average inflation rate of 3.22 percent. This means that a $100 expense will cost $103.22 in the coming year.
Other economic factors, such as the Producer Price Index (PPI) and the Consumer Price Index (CPI), are used by the Labor Statistics Bureau to compute inflation (CPI). The CPI examines market fluctuations from the perspective of consumers and tracks price variations across a variety of items and services.
While the PPI calculates prices paid by enterprises for the key items utilized in the production of products to study pricing variations from the seller’s perspective. The PPI is useful because inflation can start anywhere in the supply chain, for instance when component costs rise, the finished goods are subsequently sold at a greater price by the manufacturers.
Although the Federal Reserve is working hard to attain a rate of inflation of roughly 2%, and this is why when the rate of growth exceeds 2%, the Fed adopts a variety of steps to cut it down, including raising interest rates.
Knowing how inflation affects investments can help you make better decisions, especially if you’re an investor. With this knowledge, you’ll be able to determine which portfolio to keep to protect the value of your money when inflation grows.
The relevance of inflation
Experience and studies have been valuable teachers to the big banks regarding what must be done to keep inflation around 2% to keep the economy growing at a steady rate. Unemployment and economic despair arise as inflation falls below or changes to deflation. As inflation rises above 2%, monetary depreciation and unmanageable prices wreak havoc on the economy’s stability.
The economy, rather than being a definite and stable entity, is a complicated activity that requires a precise balance to move forward. The economy could be compared to a moving bicycle, with inflation representing the speed at which the bicycle is traveling. We will immediately lose control and crash if the bicycle is still or if we wish to ride back.
Similarly, as the bicycle accelerates, steering and maneuvering up and down the way ahead becomes more difficult. Maintaining equilibrium and gaining velocity, on the other hand, is straightforward.
Direct implications on the economy
Although many people assume that all inflation is bad, experts argue that controlled inflation is beneficial to the economy. Inflation encourages investment because it provides a way to save money as the value of dollars depreciates and boosts the confidence of businesses to hire more hands. Inflation is only dangerous if it occurs unexpectedly and uncontrollably, with prices rapidly rising to the point that all spending is halted and by extension the economic activities.
The economy is not intrinsically inflated annually. In contrast to growth, deflation occurs when the market collapses and inflation goes below 0%. Deflation is not necessarily a good thing all the time, because it often symbolizes a deteriorating economy and results in lower output and increased unemployment rates.
Now how does this affect me as an investor, you ask?
Inflation poses a subtle threat to borrowers, as it diminishes actual savings and investment returns. Most people seek to increase their purchasing power in the long run but this goal is jeopardized by inflation because investment returns must first meet the rate of inflation for actual purchasing power to increase.
So in essence, the actual interest rate is the average rate that is lower than the rate of inflation. When inflation is factored in, the actual interest rate is a better reflection of the lender’s purchasing power. For instance, if there is an interest rate of 5% and inflation is 2%, the actual rate will be 3%.