So, what is inflation?
The meaning of the term inflation is an increase in the general price level, which affects how much your money is enough for. Inflation thus means that your money decreases in value and you can buy fewer goods and services for the same amount of money. You simply have less left to live on.
Inflation means that the value of money is eroded
For the concept of “money” to work, it is required that there is a limited amount in circulation.
Had there been an infinite amount of money, we would not have been able to exchange money for goods, because money would have been so easy to obtain.
The original definition of inflation means “an increase in the money supply”. In principle, more banknotes are printed.
With more and more banknotes in circulation, we need to pay more banknotes for each item we buy.
Imagine if we used sand grains as payment instead of money.
How many grains of sand would you need to scoop out of the children’s sandbox to have enough to buy a pack of milk?
Today, inflation is used synonymously with the term “consumer price index”. It is a measure of measuring the general price development for private consumption – that is, how much the price of goods and services you and I buy increases.
In short: inflation is a measure of how much you can buy for a hundred bucks today, compared to how much you could buy for a hundred bucks last year.
You may remember that the price of a movie ticket was lower when you were a child and you have heard your parents tell you how much lower the price of a bag of sweets was when they were little.
This does not mean that everyone was richer or that everything was cheaper before, but is an effect of inflation – that a hundred bucks then is not worth as much today.
How does inflation occur?
There are many reasons why inflation occurs, here are some examples:
- If a central bank provides too much money, prices rise and the value of money erodes. The most well-known examples of times of very high inflation, so-called hyperinflation, are characterized by central banks reducing the value of money by printing large amounts of banknotes.
- Great demand – people want to buy more goods and services than companies can produce.
- If the costs of producing goods and services rise, companies may need to raise their prices to compensate for rising production costs. This may be due, for example, to the fact that wages have risen or that oil has become more expensive.
- Expectations – if companies and households believe that prices will increase, employees can demand higher wages as compensation, which companies in turn can compensate with higher prices. Expecting inflation has created inflation. This can lead to the economy ending up in an upward spiral of increased wages and prices that can be difficult to break.
Is inflation good or bad?
Inflation – and also its opposite deflation – is in principle inevitable in today’s economy.
In order for prices and wages to remain completely unchanged, it is required that all goods and services are just as easily accessible over time.
This would mean that everything from access to trained staff to the size of the farmers’ harvests would always be exactly the same from year to year.
Because we live in a global economy, where we have agreed that money is the common means of payment, there will always be a willingness to pay more for goods and services that are in demand.
In this way, the costs of both producing and consuming over time inevitably increase.
What you do not want is too high or uncertain inflation, ie that prices rise at too high a rate or that they rise and fall irregularly.
By keeping inflation low and stable, large fluctuations are counteracted. They also build up a buffer against deflation, meaning that the value of money suddenly increases.
If the value of money increases, companies cannot afford to hire, which in the long run leads to unemployment and the economy is damaged.
How does inflation affect your personal finances?
Since inflation means that the value of money decreases over time, it directly affects your personal finances in two main ways:
- Your salary becomes less and less worthwhile
- Savings that are in an account without interest lose value
Your annual salary increase
In order for you to be able to afford to live on your salary over time, you need to have an annual salary increase in line with the inflation rate.
In Sweden, the target for inflation is 2%. This means that your annual salary increase, which at least needs to be around the same.
Assuming you do a good job, continue to learn and contribute more to the company’s profitability, you should of course argue for a higher increase than that.
Saving money in an account without interest
Investing in mutual funds and stocks is not just a way to make extra money. It is also a way to protect yourself from actually getting rid of money.
No matter how tempting it may be to have a large buffer of money lying around, inflation will lead to the value of your buffer decreasing year by year.
You have managed to save $10,000 that is in a bank account without interest.
With each passing year, this money will lose in value, as inflation rises and commodities become expensive.
You will thus be able to buy fewer and fewer goods for your money, as the prices of the goods increase but the number of dollars in your account remains the same.
That is why…
Therefore, make sure that you do not have too much money lying around in a regular account. In addition to the buffer of 2-4 monthly salaries you need, the money should end up where they do the most good – and where they risk losing the least in value over time.
What is hyperinflation?
If inflation exceeds 50% per month, it is called hyperinflation. If there is hyperinflation, the whole economy will end up in crisis.
The capital markets stop functioning, foreign investors and companies take their money and flee the country, which aggravates the situation even more.
The country’s currency quickly becomes worthless. In such situations, people, for good reason, stop trusting the country’s currency and may even switch to direct barter.
The best known example of hyperinflation is the situation in Germany during the interwar period.
Germany was forced to pay large war damages after the First World War.
The German finances did not meet the requirements and the government began to print banknotes at an ever-increasing rate to be able to afford to pay damages.
Thereafter, the situation escalated rapidly and for a period inflation was 21% per day.