Inflation: Definition, Causes, and Pros & Cons
GlossaryWhat is inflation?
Inflation refers to the gradual, general increase in the prices of products and services over a certain period. This means that with the same amount of money, you can buy less than before—your purchasing power decreases, and the currency loses value. It’s a natural part of economic cycles and affects nearly everything—for example, your daily groceries or the rent you pay. The opposite of inflation is deflation; more on that later.
Not a BUX investor yet? Create your account
Where Does the Term Inflation Come From?
The term ‘inflation’ is derived from the Latin word inflare, which means ‘to blow up’ or ‘to swell.’ The value of money is, as it were, inflated, making it worth less in comparison to goods and services.
What Is the Purpose of Inflation?
Inflation is a crucial component of the economy, as it impacts the value and purchasing power of money. An average inflation rate of around 2–3% indicates a healthy economy, as it encourages spending, which in turn drives economic growth. Additionally, inflation reduces debt burdens over time, as future repayments are worth less. In short, inflation reflects a country’s overall economic health.
Central banks, such as the European Central Bank (ECB) of the European Union, use inflation targets to steer monetary policy and strike a balance between economic growth and stability. Their goal is to keep inflation around the 2% target in the medium term.
What Causes Inflation?
Inflation arises from various factors, such as:
- Demand-Pull Inflation: This occurs when demand exceeds the available supply of products and services.
- Cost-Push Inflation: This form arises from rising production costs, such as higher wages or more expensive raw materials. Companies pass these costs on through higher prices.
- Imported Inflation: This happens when price increases abroad lead to higher prices via imports. A country imports goods that have become more expensive in the country of origin, raising local prices.
- Monetary Inflation: Often the result of government or central bank policies. When there’s more money in circulation, its value drops.
- External Events: Unexpected external factors, such as geopolitical tensions, can limit product supply and drive prices up.
The Effect of Inflation on Prices
Inflation causes the rising prices of everyday items, such as your favourite chocolate bar or a train ride. This diminishes the real value of your money, so you can buy less with the same amount of money. If your income doesn’t keep up with inflation, your purchasing power decreases. It’s essential to strike a balance, as both too low and too high inflation are undesirable.
How Is Inflation Measured? An Inflation Calculator
In the Netherlands, the annual inflation rate is measured by the Dutch Central Agency of Statistics (CBS) through the Consumer Price Index (CPI). In the UK, the Office for National Statistics (ONS) measures the monthly inflation rates. This index tracks the cost of a fixed ‘basket’ of everyday products, durable goods, and services consumed by households. Some items (like electricity and water) weigh more heavily than others (like sugar).
How Is the Consumer Price Index Calculated?
Annual inflation is the percentage change in the price of the total basket in a given month compared to the same month a year earlier. Inflation in the eurozone is calculated on a monthly basis. The formula is:
CPI inflation = (cost of the basket now ÷ cost of the basket in the base year) × 100
The inflation rate is then: ((new CPI – old CPI) ÷ old CPI) × 100
These calculations provide a clear picture of price changes in the economy. This insight enables you to make informed strategic investment decisions, allowing your wealth to grow faster than the inflation rate.
The Advantages of Inflation
Moderate inflation can benefit the economy. It encourages consumers and businesses to spend or invest more, which boosts growth and employment. Another benefit is that it reduces the real burden of debt, since future repayments are made with money that’s worth less. Moreover, inflation provides investors with opportunities to grow their wealth through assets like ETFs, which can deliver returns that exceed inflation.
The Disadvantages of Inflation
Inflation also has downsides. High inflation can strain financial stability, particularly for individuals with fixed incomes, as prices rise more rapidly than they can keep pace. Additionally, savings in low-interest accounts lose value over time, reducing purchasing power. Unpredictable or high inflation can also create economic uncertainty, erode business confidence, and negatively impact investment returns. To mitigate these risks, it’s crucial to diversify your portfolio with accessible, growth-focused investments, ensuring your wealth remains resilient against inflation.
Not a BUX investor yet?
Create your account in a few minutes and start building your wealth.
Investing involves risks. You can lose your investment.
All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
