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What is inflation?

The definition of inflation

Inflation is an economic situation where the value of money falls while the prices of goods, services, and assets rise.

It usually occurs when too much money chases too few goods and services. Central banks try to control inflation by printing less money and raising interest rates.

People usually talk about inflation as one thing. But there are actually three kinds of inflation:

  • Monetary inflation. This is when the money supply increases, a decision that’s handled by the Federal Reserve in the U.S. and the Bank of England in the U.K.
  • Consumer price inflation. This is when the cost of everyday goods and services increases.
  • Asset price inflation. This is when the stock market, real estate, gold, and art.

The inflation rate can be measured by tracking the changes in prices of representative items over time. The inflation rate is the percentage change in prices from one period to another.

Effects of inflation

For example, if yearly inflation is 5%, and you have $100 in the bank, a year later you’ll only be able to buy $95 worth of goods with that same $100.

Inflation also affects investments. If you have $100 in a savings account that pays 2% interest, and inflation is 5%, then the real rate of return on your investment is -3%. In other words, you’re actually losing value by saving.

Inflation can impact different people differently. If you’re on a fixed income, inflation can reduce the purchasing power of your benefits. On the other hand, inflation can be good for people with debt because it reduces the real value of what they owe.

The causes of inflation

The cause of inflation varies by type.

  1. Monetary inflation tends to occur when a government or central bank increases the supply of money in the system, devaluing the purchasing power of money already in circulation.
  2. Consumer price inflation occurs anytime the cost to produce goods and services increases. We saw this type of increase during the pandemic, which caused supply chain disruptions. Additionally, when consumer demand outpaces the supply of goods and services available, this can also cause consumer prices to rise.
  3. Asset price inflation often happens when interest rates are low and the wealth of higher net worth individuals is growing. Since these individuals have their personal consumption needs met, their excess capital flows to financial assets.

Reasons why inflation is so high

As of August of 2022, in the US the current annual year-over-year (YoY) rate of inflation hit 8.5%.

This high rate of inflation can be attributed to increases in household demand, continued supply chain issues related to the pandemic, and a “tight” labor market, meaning vacant jobs are plentiful and available workers are scarce.

Is inflation always bad?

No, inflation isn’t always bad.

In fact, economists generally agree that a small amount of inflation is good for an economy. That’s because inflation can encourage spending and spur economic growth.

But when inflation gets too high, it can be detrimental to an economy. High inflation can cause people to lose faith in their currency, leading to decrease in spending. This can lead to economic stagnation or even recession.

In the 1970s, inflation in the United States hit an annual rate of more than 10%, peaking at 13.5% in 1980. This high inflation, combined with high interest rates and oil prices, caused a recession that lasted from 1981 to 1982.

Bitcoin as a hedge against inflation

Bitcoin was created in 2008 in response to the global financial crisis.

The idea was to create a decentralized currency that couldn’t be inflationary like government-issued currencies.

In fact, one of Bitcoin’s most appealing attributes was its resistantance to inflation. Unlike currencies like the U.S. dollar or Euro, there can only ever be 21 million bitcoins.

Since its inception, Bitcoin has generally increased in value much faster than the US dollar and other currencies have lost their value. While the Bitcoin market can be volatile, the trendline in its price over time has been upward.

While the short term prospects of Bitcoin may remain volatile for years to come, Bitcoin has become an increasingly popular long-term hedge against the inflation of government currencies.

Inflation, summarized

  • Inflation is a general increase in prices and fall in the purchasing value of money.
  • It occurs when there is too much money chasing too few goods and services.
  • The inflation rate can be measured by tracking the changes in prices of representative items over time.
  • There are different types of inflation, which are caused by different factors.
  • Inflation is generally bad for an economy as it can lead to stagflation (a combination of high inflation and economic stagnation).
  • Bitcoin was created as a hedge against inflation, as its limited supply means that it cannot be inflated like government-issued currencies.

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