What exactly is…inflation?

Introduction

…a seemingly unwieldy term meaning that prices in an economy increase over time. Or to put it another way, inflation means that money loses purchasing power.

Here’s an example to illustrate this:

Imagine you have 10 euros you’d like to use to buy fresh strawberries at the market. Let’s assume a container of strawberries costs 2.50 euros. So for these 10 euros, you’ll get four containers of strawberries. Now imagine you go to that same market two weeks later, again with 10 euros in your pocket, to buy more strawberries. But now a container costs three euros, so you only get three containers of strawberries (and a little change back) instead of four.

The prices have gone up, and you can’t buy as much with your money. In reality, prices of course don’t rise so quickly and sharply. This little strawberry example is just to illustrate what’s going on.

Still though, the price of every item, product, and service in an economy is constantly fluctuating. Political crises affect the price of oil, research and development send technology prices tumbling…do you still remember how expensive smartphones were a few years ago? All of this is based on interactions between the supply and demand of many different submarkets. These could be your local market around the corner; the market for loaves of bread, salon appointments, or cars; or commodities such as oil or precious metals.

Essentially, prices always go up when demand is somewhat higher than supply. If your stomach is growling and you’re plodding along through the train station or highway rest stop before a long trip, that’s when you’re most likely to be willing to pay more for a sandwich or prepackaged fruit salad. Not when you’re in the middle of the big city, where there’s a bakery just past a snack stand and a supermarket just past that. To boil it down, your willingness to pay a higher price is especially strong when you’re really hungry, or when the food supply is low (that is, scarce).

Let’s stay with the market for bread example for a minute. When the grain harvest doesn’t yield a whole lot after a long, hot, dry summer, the price of baked goods then goes up. Why? Because the commodity a baker needs has now become scarce. They’ll have to buy their grain (or flour) for a higher price because there is less of it due to the heat. They’ll then pass these price increases on to their customers…and so the price of bread and rolls goes up.

These and very similar effects lead to inflation in every possible large or small (sub)market. How high is it? Good question, ’cause…it varies. In the eurozone, the European Central Bank (ECB) has the task of keeping prices somewhat stable. It specifically defines that “it aims for an annual rate of inflation of ‘below, but close to, 2% over the medium-term.’ ” It’s actually sitting around 2.1% right now in Germany, 1.6% across the entire eurozone.

Why is inflation actually a good thing? Because it’s the best buffer against deflation (the opposite of inflation): falling prices. Sounds good at first, right? Prices are dropping, everything is getting cheaper, yay! But…imagine you know for certain that in one year, absolutely everything is going to cost less than it does today. This expectation would most certainly affect your purchasing decisions! You would probably wait a while to make a big purchase – to upgrade your washing machine or your couch, to buy a new car or install a new kitchen. We’d all put off big purchases to a later point in time…probably even indefinitely. Why? Because we could pretty much expect that a product would be cheaper tomorrow compared to today, and even cheaper the next day…

This situation would be pretty catastrophic for companies. After all, they wouldn’t be able to sell much of their product today, and probably not even tomorrow. The reason why is that the demand will drop. And drop. And drop. This means that companies will produce less and will eventually have to lay employees off. These people will stay unemployed given the circumstances, have less money in their pockets, and demand fewer products and services. These mutually amplifying effects would lead to a downward spiral across the entire economy.

That’s why small to moderate transient price increases are better than sustained price drops.

Price increases gnaw away at the value of money

If you temporarily stash your money in a bank account for a couple weeks or for a few months, the topic of inflation might seem pretty irrelevant to you. Its relevance to you increases over the long term. Imagine you set aside 1000 euros today. Annual inflation causes the purchasing power of your money to drop over the course of time. Small price increases within the economy mean that you can buy fewer products and services with your money tomorrow and the day after compared to today. And the results are glaring. Assuming an annual inflation rate of 2%, in 10 years, your money would have the purchasing power of 820 euros, of 670 euros in 20 years, of 550 euros in 30 years. In other words, in just over three decades, the value of your money has been halved. Due to inflation alone. That’s why it’s all the more important that you invest your money well and get those healthy returns. If you let it slumber away unused in your bank account, it will lose value…and that’s the exact opposite of what you want!