What is Inflation?
Lately, we have been hearing about rising inflation all around the globe; however, not everyone understands what that is about and how they are affected by it. Until not so long ago, I was clueless about what those figures were until I started researching and acquired a bit of financial education.
That said, I will try to explain what it is, how it is produced, and what the consequences are for individuals. As a disclaimer, this is just an approximation to the phenomenon, so for a more academic understanding, consult other sources 🙂
Let’s imagine that the whole world population is 100 people and that the total amount of money is 100 euros and each person has 1 euro. In this case, the purchasing power of each person is 1/100, which equals 0.01 or 1%.
On top of that, let’s imagine all the things you could buy in the world. They are concentrated in a big pot of soup, where 1 euro would get you 1/100 of that soup. From a different angle, a person that owns 1% of the money can purchase 1% of the soup.
Considering the previous scenario, let’s imagine that one person manages to counterfeit more coins that are identical to the ones in circulation, and no one can tell the difference. So this person mints now 10 more euros that add to their initial 1 euro. Now, in our fictitious world, we have 99 individuals with 1 euro, 1 individual with 11, amounting to 110 euros in total. The pot of soup continues to represent the world’s money.
Now the question we would need to ask ourselves is, What is the purchasing power of each person? Let’s see:
- The purchasing power of an Individual with 11 euros is 11/110=0.1 (10%). Before, it was 0.01 (1%).
- The purchasing power of an individual with 1 euro, or in different words, the purchasing power of 1 euro is 1/110=0.009 (0.9%) before it was 0.1(1%)
Notice that the individuals here have lost some purchasing power without them noticing.
I started this post by saying that all the wealth in the world was concentrated in one pot of soup, so in scenario B, all the money in the world is 110 euros. Therefore the price of the soup becomes 110 euros. The soup has not changed in value, it is the same soup, and it serves the same purposes as before, it has changed in price because now 1 euro is less valuable than before, so now you need an extra 10% in order to get the same amount of food as before.
In the real world, the amount of currency is increased over time for different reasons, which produces a devaluation of the currency, which is why prices rise to compensate for it. During the last decade and especially in the last two years, as a reaction to the pandemic, governments worldwide through their respective central banks have injected an incredible amount of new currency into the system, accelerating the devaluation of the currency and the price increase. Interestingly, almost 40% of the dollars existing in the world have been created in the last 5 years.
USD-M2 Money supply in Millions
It is important to note two characteristics here. First, the loss of purchasing power is invisible to the individuals because their bank accounts reflect the same amount, regardless of the CPI value. Second, in most cases, inflation is the consequence of political decisions. Since the governments and the central banks hold power over the money supply increase, entrepreneurs have nothing to do with it.
Wrapping up, we can now understand that rising inflation means loss of purchasing power, means that we can purchase fewer goods with the same amount of money, and means that we will still have the same amount of money, but prices will rise. But How much are we losing based on the CPI number?
Here are some numeric references:
- With a 2% inflation, you would lose a third of your purchasing power in 18 years.
- With a 3% inflation, you would lose a third of your purchasing power in 12 years.
- With a 5% inflation, you would lose a third of your purchasing power in 9 years.
- With a 7% inflation, you would lose a third of your purchasing power in 5 years.
- With a 10% inflation, you would lose a third of your purchasing power in 3 years.
That applies to any amount of money you have in your bank account and the future money you would earn.
As a silver lining, for those who do not live from paycheck to paycheck, you can find ways of protecting yourself against it; you can start by browsing in youtube “How to protect myself from inflation” and you will find some initial ideas, then just jump from video to video until you find something that resonates with you.
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