In Part 1, we talked about what inflation is and how it works.
Since inflation means that the prices of good goes up, does this mean that inflation is bad for our economy and should be avoided at all costs?
Inflation is often known as the necessary evil of the economy. Economists argue that a controlled rate of inflation actually has a positive effect on our economy if it supports economic growth.
Inflation supports Growth
Inflation is the result of increase in demand of goods and services in the economy. This could also mean that there is an increase in consumers’ income and decrease in interest rates from commercial banks. The demand in goods also could cause the price to increase and firms would increase their production in future to meet the expected demand in order to maximise profits. The rise in production in turns creates jobs and income rises further. Hence, GDP could increase and lead to growth in the economy.
Therefore, governments around the world try to control the rate of inflation within a certain range (typically ~2%). Developing countries tend to experience a higher rate of inflation.
Inflation out of control
It is not uncommon to mention Venezuela when discussing the topic of hyperinflation.
Venezuela’s inflation rate just hit a new high, rising more than 40,000% annually. The drop in oil prices caused the socialist state to print currency bills in massive amounts and flooded the economy. With an enormous amount of money chasing limited of goods, this caused prices of goods to skyrocket overnight and the collapse of the socialist state soon followed.
Rise in prices does not always mean inflation
Not all increase in prices can be attributed to inflation, especially so when the demand of goods increases due to speculation. Speculation involves the trading of a financial instrument involving high risk, in expectation of significant returns, taking maximum advantage from fluctuations in the market. Speculation causes a bubble to form, whereby the trading assets are trading at prices that strongly exceeds the asset’s intrinsic value.
A prime example is the subprime mortgage crisis in July / August 2007 whereby low-quality subprime loans were given to NINJAs (no income, no job, no assets). Anyone could get a housing loan with minimal interest rate, and this caused the prices of houses to skyrocket. Soon after, defaults on these NINJA loans caused the subprime mortgage crisis. The problem of a bubble is that it depends on an ever-increasing number of buyers, each person is betting on selling the asset to the next buyer at a higher price, eventually, it comes to a point where the high price cannot be justified and leads to the bubble bursting.
What does inflation mean for you?
The Core Inflation Rate in Singapore averaged 1.92 percent from 2009 to 2018.
The interest rate of a normal saving account is 0.05% per annum. This means that you are actually losing purchasing power by parking your money in a savings account. Therefore, to protect our wealth against inflation, we have to consistently invest in the stock market as companies can increase their prices naturally during inflationary periods. Therefore, we have to equip ourselves with financial knowledge and start investing early to take advantage of compound interest and protect against inflation.