Basics of Inflation
On the Basics of Inflation
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Inflation, simply put, is the decline of the value and purchasing power of a currency​ over a period of time, most often due to an increase in the money supply. As inflation increases, the prices for goods and services also rise as your money buys less for each dollar you have.
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Inflation affects the economy like no other metric - the purchasing power of your dollar, the returns on your 401(k), the value of the housing market, and even the entire global currency system can all be traced back to the movement of inflation.
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The Causes of Inflation
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Rising inflation in most circumstances is considered bad for the economy. Inflation occurs when a nation's money supply (total currency in circulation) exceeds economic growth, which leads to a decline in consumer purchasing power.
This could happen due to a variety of factors. The government could artificially inflate the economy by printing money and giving it as a stimulus, corporate bailout, or adopting quantitative easing (the purchasing of stocks, bonds, commodities, or other financial assets by a nation's central bank).
Typically the government will resort to these measures in an already worsening economy, and while the economy often rebounds in the short-term as a result of these actions, the long-term consequences may be more destructive.
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The Effects of Inflation
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Inflation can have drastic consequences if left unchecked. High inflation destabilizes the economy, goods and services increase to unreasonable prices and unemployment rises as a result of the worsening economy. Runaway inflation is bad for both consumers and businesses.
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When inflation occurs, it is likely that many consumers will take it as a sign to spend their money before the cost of goods and services increases further, stocking up on consumables, filling their gas tanks etc., which in turn actually creates more inflation. This is why central banks exist to use monetary policy to keep price increases and inflation in check.
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Inflation is typically good for those who have existing debt (as $10,000 in debt is less massive if the value of the dollar is decreased), and also good for those who own equities like property and stocks (their value will go up). Conversely, this also means inflation is bad for those looking to acquire stocks/property, and those who have cash in savings accounts, as inflation will massively overtake saving account interest returns and diminish the real value of your money.
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Another effect of inflation is the possibility that you will be taxed more. Your earnings may be inflated to account for rising costs of goods/services and push you into a higher tax bracket making a higher percentage of your income taxed.
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Finally, high inflation can cause over-investment into the economy as more and more people invest into the stock market. this over-investment can cause "bubbles" in the economy, which caused the "Dot-Com bubble" and 2008 housing bubble and recession.
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Deflation Isn't Great Either
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Deflation, the opposite of inflation, isn't necessarily great either. While no one will argue against the positive economic effects of your dollar being able to purchase more, the negative effects outweigh the benefits.
Deflation can make those already struggling with debt crippled by it, as the real value of their debt increases as deflation occurs. Deflation also makes stocks/property worth less, which causes less investment into the economy and slows economic growth significantly, often causing more deflation.
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Optimum Inflation Rate
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After trashing inflation, and federal policies that contribute to it, it may be shocking to read that inflation in small amounts is actually necessary to promote a healthy, thriving economy with increasing exchanges of goods and services. A 0% inflation rate wouldn't encourage investing, and would make recessions extremely hard to get out of.
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A low, consistent inflation rate makes economic recessions more bearable as the impact of the recession is lowered as time goes on. A low inflation rate encourages consumers to invest in the stock market or purchase a home, while also making sure that those with debt aren't crippled by it.
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A low inflation rate also ensures that your wages will grow to accommodate the inflation rate, and that those who choose to put their money in a savings accounts won't see the value of their money washed away.
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Most economists suggest that an optimal inflation rate is around 1%. Unfortunately, the average rate of inflation in the United States tends to be slightly over 3%, meaning prices tend to double around every 20 years.
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How to Protect Against Inflation
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As discussed before, the best way to hedge against inflation is to own equities like stocks and real estate. Many older people like to swear by commodities like gold and silver because gold will still retain some value by itself even when the dollar falls, but gold historically hasn't been a great hedge.
Gold itself doesn't really create any value like stocks do - it isn't a business that creates products or employs people. It also doesn't pay out dividends or contribute to economic growth like a business would. Gold's price is based solely on supply and demand, which typically falls during hard economic times. Finally, inflation is hard to predict, which makes gold a speculative asset, and if you're wrong, you will miss out on the historically higher gains that the stock market offers.
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A new way people like to hedge against inflation is cryptocurrency. Their reasoning is that since no federal or corporate body controls the supply or exchange of crypto, the price of crypto cannot be artificially inflated by monetary policy. And it is true that when inflation rises, crypto rises as well.
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In conclusion, diversify your investments, consider even adding a small amount cryptocurrency to your portfolio, purchase property or REITs, and you should have a portfolio that can weather periods of high inflation.