Inflation: Causes, Impacts & How to Secure Financials
If you think that inflation does not affect me. Then you’re 100% wrong and it means that you do not understand this most important economic term. And the fact is that, it affects every person in the world in someway or the other. It’s repercussions are on businesses, investments and especially credit and loans and ultimately your day to day finance.
If you have been asking yourself what is inflation and how does it affect us? Then don’t worry.
This article tries to explain in the simplest possible way about inflation. And also covers tips on how to maintain good financial health when inflation strikes.
Inflation is an economic activity where, simply put, there is an increase in the prices of goods and services. That is to say, most of the products sold in the market see a constant increase in price. And the price increase can be both on a local and global scale.
As inflation increases, the prices of goods and services, a person’s purchasing power is significantly reduced. A very clear example is spending on food supplies.
You’ve probably noticed that “you can’t afford to shop for groceries like before”. This, believe it or not, is a sign of inflation.
There are also different types of inflation. The simplest examples are controlled inflation, moderate inflation and high inflation. Each of these represents how severe it is. Ideally, a country aspires to have no inflation or, in a given case, controlled inflation.
What causes inflation?
There are many causes of inflation. Many of them may be the result of situations beyond the control of the country. Financial crises, product shortages, wars, to name a few. However, there are four main causes worth keeping in mind.
- Increase in the monetary base
By increase in the monetary base means the issuance of more banknotes and coins. That is, the amount of money in a country. For example, suppose a country has 100 million banknotes circulating in its economy and one day decides to double that amount. What would happen? Wouldn’t the country become richer?
The answer is NO. The only thing that would happen is that the value of the currency would drop dramatically. This happens because as there would be more money, there would be a greater desire to spend it, so the prices of goods and services would only increase further. In the long run, “inflated” money will cause the currency to lose value relative to other currencies.
- Increased demand
This cause is directly related to the law of supply and demand. Remember that the greater the supply of a product, the lower its price will be. Likewise, the higher the demand for a product, the higher its price will be. And this is quite normal, imagine that there is only one phone for sale and twenty users who want to buy it. Naturally its price will go up.
Now imagine that this happens on a larger scale and the demand for goods and services is above its production capacity. Unable to meet the demand for this product, it is sold at a much higher price. This applies to any product, from cars, houses, digital devices, food and more.
- Cost inflation
Now, why do prices go up if there is no production problem? Prices of goods and services can go up because of an increase in raw material prices. For example, to make shirts a producer needs fabric. Suppose that from one day to the next cotton goes up in price but the shirt producer does not want to lose his profit.
In this case, if the producer does not want to lose money he will need to increase the price of his shirt to offset this increase in his production. Now imagine what happens when resources like oil rise sharply in price. Almost all products will do the same because oil is used for almost everything.
- Expectations inflation
This type of inflation occurs when a commodity, product or service is expected to rise sharply in price. In order for the increase not to be radical, the price of that product or service is increased gradually. This ensures that the population continues to have access to this product and is not frightened by an unexpected increase.
For example, let’s assume that milk is expected to rise in price due to a cow crisis in the country. It is estimated that in one year milk will cost 30% more. In this case, the price of milk can be increased by 2.5% monthly so that the population continues to have access to the product. In this way, when the year passes, the user has already made financial adjustments to continue buying the product.
Consequences of Inflation
Now, the most important thing about inflation is to know its consequences and how it can impact our finances. While it is true that the first consequence is reflected in our pocket, it can also affect our investments, loans and credits. Here’s how this happen.
- Increase in basic interest rates
Just as users suffer the effects of inflation on their pockets, so does the country/state. One way to protect against inflation is to raise base interest rates.
In other words, the central bank of a country sets a base rate for the financial sector that determines the price of credit in that country. In case you did not know, private banks also borrow and usually do so from the central bank. So if the base interest rate rises, the interest rate set by the private bank will rise as well.
How does this affect us? First of all, if the basic interest rate increases, it will be more difficult to obtain credits and loans, especially car and mortgage loans from banks. In case of obtaining these credits, the interest will be higher and it will cost you more money to pay them.
- Increased credit card interest rates
Remember that in times of inflation no one wants to lose money and banks even less. To counteract this increase, they will increase their own interest rates.
This applies to personal loans and credit cards that are revolving in nature. When there is an increase in credit card interest rates, the first affected is the credit creditor. Nobody wants to pay more interest, do you agree?
How does it affect us? Mainly in the amount of money you will be paying to the bank. For example, if a bank used to have a rate of 15% for a 5-year loan, in times of inflation it can be 25% or more. That means 10% to 15% more than what it would have cost you before.
- Higher revolving user payments to banks
With an increase in credit card rates, there is also a higher probability of debt in case of late payments. As you well know, not paying our credit cards generates interest. Most credit cards have variable and mixed interest rates. That is to say, they are fixed according to the money market supply.
If for some reason a user is in debt and due to inflation the interest rate increases, then the variable interest on the card will also increase.
The higher the interest rate, the more money you will have to pay to the bank and the more difficult it will be to get out of debt. This can lead to an irreversible financial health problem.
- Increased need for debt refinancing
One consequence of inflation is the increased need for indebted borrowers to refinance their debts. Since they are unable to pay off their debts, the option of negotiating directly with the financial institution or finding a third party to do so is an immediate way out of the problem.
However, negotiating directly with the financial institution and refinancing the debt with a third party is something different. It is true that you can negotiate a write-off with the financial institution to reduce the amount of your debt. However, this can cause a negative report in the credit bureau and will affect your score.
Renegotiating the debt with a third party is another option, which can also be beneficial for you.
Tips for good financial health during inflation
So what can you do in times of inflation? Don’t worry, it’s not all bad news, there are strategies and financial habits that you can implement to counteract inflation.
Remember that there are many recommendations, but there may also be many more that work for you.
- Consider not taking out loans
Borrowing is not a bad thing, you just have to know when to ask for them and under what conditions they are granted. As explained before, interest rates can be higher during inflation and if you want to invest your money in a better way, applying for a credit or loan with high rates will not help you much.
If you need that loan to operate your business or start one, research the terms of the loan. You can also pay it off faster if the financial institution allows you to do so. The most important thing is to avoid paying high interest rates that will reduce your income and your ability to pay.
- Invest more than you save
This is a tip for those who are savers. During times of inflation the money in the bank is subject to lose value. Inflation causes currency to lose value, so what happens to all the money you have saved in the bank? It will also lose value. What one year ago bought a certain amount of products, the next year it might buy less.
What can you do then? Invest. If you invest in markets that are not in inflation or even in equipment or businesses, our money will be worth more. Why? Because it’s not money, it’s something tangible that can generate income.
- Advance the purchases you can
By the same logic, anticipating purchases can save you money. Quite simply, if you buy something before its price goes up, you will benefit. If you run a business or make constant purchases, this can help you. While this is subject to the liquidity, but if you can afford it, you have to do it.
For example, let’s say you have a photography studio and you are buying lights very often. You can take advantage of this and buy a year’s worth of lights, so you will have purchased them at a lower price than they will be in a year’s time. It may seem obvious, but this is a great strategy.
- Control your credit cards
Part of good financial health is not falling into debt, especially credit card debt. This is a priority during times of inflation as you need to avoid paying interest at all costs. As explained above, this is one of the most severe problems you can acquire. Be very careful.
It is recommended you to always keep your credits at 30% of the credit line and always make the payment on time so as not to generate interest. However, if you can pay the total amount of the debt, it is much better. The important thing is to have this product under control.
- Pay off any debts you have
Finally, the most important step is to pay off any debts you have. Better yet, prevent any debts you may have. In order to avoid interest, it is recommended to pay total debt, if you have the sufficient money. But what if you don’t have that liquidity? Don’t worry, there are ways to do it.
One of them is to refinance the debt but with a lower interest rate than the bank. This way, you pay off that debt, and you only pay the monthly payment at a fixed interest rate.
Hi, I am Nikesh Mehta, owner and writer of this site. I’m an analytics professional and also love writing on finance and related industry. I’ve done online course in Financial Markets and Investment Strategy from Indian School of Business.