What is Inflation?
What exactly is inflation, and how does it affect your small business? In short, inflation reflects a reduction in the purchasing power of money – a loss of real value in the medium of exchange. In this article, we’ll explain what inflation is and how you can protect yourself from its effects. Let’s get started!
What is Economic Inflation?
Economic inflation is an increase in core prices and wages relative to a baseline level of prices and wages. The core inflation rate is the year-to-year change in the core index, which is calculated by the Bureau of Labor Statistics. This rate doesn’t include the volatile food and energy component prices so it tends to be a more accurate predictor of future inflation.
What Causes Inflation?
There are many causes of inflation and below we will be discussing four of the main ones:
Cost-push inflation occurs when the prices of production inputs like raw materials and energy increase. Businesses begin raising prices to maintain profit margins, and this price hike gets passed on to consumers.
Demand-pull inflation happens when there is too much money chasing too few goods. It can be caused by rapid economic growth, an increase in government spending, or a decrease in taxes.
Supply-side inflation happens when there is a decrease in the supply of money or an increase in the demand for money. It can be caused by a Central Bank setting interest rates higher or by people hoarding cash.
This happens when the prices of stocks, bonds, real estate, and other financial assets increase. It’s often caused by easy credit conditions and can lead to an economic bubble.
How Does Inflation Affect The Economy?
It’s important to know what inflation is and how it affects the economy. Below, we will take a look at five leading economic inflation indicators:
In general, prices rise when the demand for goods and services increases. Oil prices are a good example. When the global demand for oil increases, the oil and gas prices increase also. Fuel inflation causes energy prices to increase resulting in the price changes of other goods and services increasing too. These higher prices mean price increases to transport goods when fuel prices are high and there’s less price stability.
Interest Rates Rise
In order to curb inflation, the Federal Reserve (the central bank of the United States) will often raise rates of interest. Raising interest rates makes it more expensive for people and businesses to borrow money, which can lead to slower growth in the economy.
Stock Prices Fall
When inflation is on the rise, prices of stocks usually fall because investors are worried that the high prices will eat into corporate profits. They also believe that the Fed will raise interest rates to try to control inflation, making it more expensive for companies to borrow money and expand.
Dollar Loses Value
Inflation can cause the dollar to lose value because when prices go up, the purchasing power of the dollar goes down. And when the purchasing power of the dollar goes down, people are less likely to want to hold onto their dollars.
Wages Lag Behind Prices
Inflation can also cause wages to lag behind prices meaning that people’s incomes may not keep up with the rising cost of living. Thus, inflation can lead to a decrease in the standard of living.
The annual inflation rate is the percentage change in the price index from one year to the next. The economic growth rate is the percentage change in real GDP from one year to the next. Let’s take a look at the main ways inflation is measured:
The Consumer Price Index
The Consumer Price Index (CPI) is the most widely used measure of inflation. It measures the prices of a basket of goods and services that are bought by households. Central banks use the CPI to help them set interest rates.
The Producer Price Index
The Producer Price Index or PPI measures the prices that producers receive for their goods and services. It’s a leading indicator of inflation and can be used to predict changes in the CPI.
The Gross Domestic Product Deflator
The GDP deflator is a measure of the overall level of prices in the economy. It’s calculated as the ratio of nominal GDP to real GDP. The GDP deflator is a broad measure of inflation and is often used to compare inflation rates across countries.
How Long Does Inflation Last?
Inflation can last for years, or it can be a short-term problem. The 1970s was a time of high inflation in the UK and worldwide. The reasons for this were an oil crisis and high government spending. In the early 1990s, rising prices of oil and the reunification of Germany led to inflation in Europe. And in 2008, the global financial crisis led to a period of high inflation in some countries, particularly those with weak currencies.
How Small Business Owners Can Deal with Inflation
Economists are expecting consumer prices to hit 6.9% in 2022 on average. Long-term inflation expectations have an inflation target of 2.4% at some point in 2024. Here are five ways small business owners can deal with inflation:
Review your pricing strategy. Regularly review your pricing strategy to ensure that your consumer prices are in line with the cost of goods and services. You may need to raise prices to cover the cost of consumer price inflation.
Monitor your suppliers. Inflation can increase the cost of raw materials and other production costs. Monitor your supplier costs closely and be prepared to switch suppliers if necessary.
Hedging against inflation. One way to protect your business from inflation is to hedge against it. This can be done through financial instruments like inflation-linked bonds or commodities.
Increasing productivity. Another way to deal with inflation is to increase productivity. This can be done by investing in new technology or improving processes.
Business Diversification. Diversifying your business can also help to protect against inflation and increase your business’ money supply. This can be done by expanding into new markets or products.
Planning Ahead and Taking The Positives
Planning ahead can help your business to survive and thrive during periods of high inflation. Here are five key takeaways inflation can be positive for your business:
Good for businesses. Inflation can be a sign of economic growth and can lead to increased demand for goods and services.
Can be good for debtors. Inflation can reduce the real value of debt and make it easier to repay.
Inflation can be good for savers. Inflation can increase the real value of savings and make them grow faster.
Really good for pensioners. Inflation can increase the real value of pensions allowing them to grow at a faster rate.
Great for businesses with fixed costs. Inflation can increase revenue and profit margins.