What is inflation? Why are some people frustrated with inflation? How is inflation calculated? Find out all of this and more in this Finance Storyteller video!

⏱️TIMESTAMPS⏱️
0:00 Introduction
0:14 Definition of inflation
0:25 Effect of inflation on wages
1:04 How is inflation calculated
2:05 Personal inflation
3:00 Inflationary spiral
3:47 Hyperinflation
4:18 Effect of inflation on salaries, savings and debt
5:13 Role of central banks in controlling inflation

Inflation is the action of inflating something or the condition of being inflated. When we discuss the economy, #inflation means an increase in prices.

To most people, inflation is the story of a salary increase that vanishes. Jim just got home from work after his annual performance appraisal. He got a small salary increase of 2%. Nothing spectacular, but at least his salary is going up. On the same day, the latest inflation numbers are published: prices have gone up by 1.5% in the past twelve months. If Jim gets a nominal salary increase of 2%, while inflation is 1.5%, then the “real” growth in his purchasing power is around .5%. Frustrating, isn’t it?

So how is this 1.5% inflation calculated? The 1.5% is the outcome of a lot of data gathering, and a lot of calculations, for a profile called the “typical consumer”. A typical consumer spends 17% of income on housing (rent, housing maintenance, water, electricity, that kind of stuff). Prices for housing have gone up 2.6%. A typical consumer spends 15% of income on transport (buying and running a car, and using other transport services). Prices for transport have gone up by 1.2%. The list goes on and on. Some categories, like alcohol and tobacco, might have prices that are up 4%. Other categories might even see a price decline. Inflation is the weighted average of the price increases or decreases by category, using the % of income as the weight.

How about we give Jim a bigger salary increase of 6%? That could work if Jim and only Jim gets 6%, while everybody else gets 2% or less. If a lot of people in a country get a 6% salary increase, then the cost of producing goods and services would go up, and companies might pass on this cost increase in their selling prices, driving up inflation. This is called a price-wage spiral: price increases causing wage increases, and wage increases causing price increases. Jim would still have “real” growth in his purchasing power of around .5%. And he would still be frustrated.

If the price-wage spiral gets out of hand, a country could get into a very turbulent situation called hyperinflation. This is when you use a wheelbarrow as a wallet, as you need a big pile of cash to buy a loaf of bread. Or when the price of your cup of coffee has doubled between the time you order it in a restaurant and the time you ask for the bill. Hyperinflation can cause a lot of economic and social instability, and most countries try to avoid it.

What is the effect of inflation on salaries, savings and debt? As we saw in Jim’s example, inflation can make salary increases vanish. It will also “eat up” part of your savings, as these will have less purchasing power in the future. Hopefully your savings get you an interest rate that is higher than inflation. Inflation also “eats up” part of your debt, so depending on how much debt you have, inflation might actually be a net positive for you.

Inflation is not a new phenomenon. Copernicus (yep, that’s the same guy that figured out that the earth revolves around the sun) wrote about it in the early 16th century. He observed an increase in prices following the import of gold and silver, used in the coinage of money, from the New World.

Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better #investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!