Inflation may be the culprit for increased candy bar prices and the disappearance of five-dollar-foot longs, but the effects of inflation run much deeper than candy bars and subs. It’s important to understand what inflation is and how it impacts your short-term and long-term goals.
What is Inflation?
Inflation is the rate at which prices for goods and services increase. It can be analyzed on a broad scale, or specifically calculated for specific industries or products. It’s measured based on consumers’ cost of living which is heavily affected by the price of goods and services like food, rent, gas, education, healthcare, entertainment and so on. The annual cost of living based on household surveys conducted by government agencies is represented as the consumer price index (CPI). The percentage change of the CPI year to year is the rate used to represent consumer price inflation. For example, if the CPI was 100 last year and this year it is 103, inflation rose 3 percent this year.
Why Are Prices Increasing?
It’s clear that inflation occurs when prices increase, but what makes prices increase? Many factors influence price, let’s explore some of the most common factors.
Increase in Production Cost
Production cost includes raw materials and wages. If the demand remains the same while the cost of raw materials and/or wages increases, the prices for goods and services must be increased to keep up with the demand by consumers.
For example, let’s say 10 people wanted a basket of honey-crisp apples last year. The cost for soil, apple seeds, water, and farming wages averaged out to five dollars a basket. This year, 10 people still want a basket of honey crisp apples, but the cost of soil and apple seeds increased. Due to this increase in production cost, the price for a basket of honey crisp apples must be increased.
Unfortunately, our economy isn’t as simple as this honey-crisp analogy. Wages are often a highly disputed factor regarding inflation. Wages are incredibly important to fully compensate employees’ time, education, skills, and risk. If wages are increased too much outside of a company’s budget, production costs increase and so do prices for consumers.
High Consumer Demand
As consumer demands for products and services increase, the supply of these products and services decreases. If the supply is low and the demand remains high, consumers are willing to pay higher prices. This cat-and-mouse game of supply and demand can be affected by many factors including the level of unemployment, consumer wages, brand names, and so on.
Going back to the honey-crisp example, let’s say 10 people wanted a basket of honey-crisp apples last year. This year the same number of apples were harvested, but now 30 people want a basket of honey-crisp apples. Since honey-crisp apples are in high demand and the supply is low, the price should be increased.
The increase in demand from consumers gives power to corporations. For everyday items like gas and oil, companies can freely adjust the prices since the products are always going to be in demand. Similarly, well-recognized brands that sell popular products can increase prices simply because they know consumers are willing to pay higher prices. Corporations must be smart about adjusting their prices and pay attention to factors like the level of unemployment and consumer wages to set realistic prices for consumers.
Too Much Money
As the supply of money grows, its value decreases. The more money there is, the less purchasing power it holds. This concept is easier to understand when thinking about money as any other good.
For example, let’s pretend a five-dollar bill is an apple. If we harvest too many apples, we’re going to be left with a surplus supply of apples and not enough demand to circulate through consumers. There’s going to be too many apples than mouths to feed and many apples are going to lose their value.
This is similar to the amount of money produced in an economy. If an economy can’t produce enough goods and services to keep up with the amount of money in circulation, then prices must be increased.
How do I Protect My Finances?
According to economists, inflation is expected to gradually occur no matter what so it’s important to know how to protect your finances and adjust your spending to best support your financial future. Talk with your financial advisor for help with allocating your funds. This might come in the form of investing in irreplaceable goods like land or real estate, investing in stocks that grow over time, reassessing retirement funds, or simply reevaluating your budget. Contact us today for help protecting your finances amid inflation.