9 Effects of Inflation and How to Protect Yourself

Inflation has been our preoccupation in the last few months because of the sudden increase, but it’s far from a new phenomenon. 

Inflation is well known and studied in the economy, and knowing the effects of inflation, why it occurs, and how to protect your finances can help you live through it. 

Therefore, in today’s article, we will be talking about:

  • What is inflation?
  • Positive effects of inflation
  • Adverse effects of inflation
  • The best way to protect your finances

Let’s jump in!

Basics of Inflation

Inflation is the constant increase in the price of goods and services. As a result of inflation, the money value decreases over time. An important note is that inflation affects all prices around us, not just particular ones.

Moderate inflation is connected with economic growth, while higher inflation signalizes an overheated economy. Due to rising prices, consumer spending falls off. Since consumer spending drives economic growth, with persistently high inflation, we have slow economic growth.

There are many possible causes of inflation. Our global economy in the last year has dealt with inflation, and the main reasons for that are pent-up consumer demands, economic stimulus from the pandemic, and supply chain issues.

Change in consumer price index over the years

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How Is Inflation Measured?

Inflation denotes the rising prices in the overall economy. However, inflation can be calculated more precisely for individual commodities and services. 

When economists and central banks try to differentiate the inflation rate, they usually focus on ”core inflation” such as ”core consumer price index (CPI)”.

The official estimate of consumer price inflation is the consumer price index (CPI), calculated by the U.S. Bureau of Labor Statistics

They calculate CPI by monitoring the average change in prices people have paid for goods and services and categorize it into eight groups: food, housing, medical care, transportation, recreation, apparel, education and communication, and other goods and services.

As prices in the period of inflation rise, things you can buy now will lessen over time. To keep up with inflation and be able to combat it is one of the main reasons to invest your money.

If you save money in your bank account and do nothing with them, in future years, that sum will not be the same, and you will probably lose a lot. That’s why we always say that money’s nature is moving, and for you, it means – investing.

Inflation has its effects on everyone. 

Consumers are worried about inflation because it affects costs and their living standards. Businesses care about raw materials prices because they are crucial for their products and the wages they need to pay their employees. 

Higher taxes, government spending and programs, interest rates rise, and much more are affected by inflation.

Types of Inflation

  • Walking inflation

Walking inflation occurs when the rising rate is 3% to 10% per year, which is our current situation. Creeping inflation is milder than walking while running inflation indicates a more aggressive increase in prices that often is a precursor to hyperinflation.

  • Demand-pull inflation

Demand-pull inflation occurs when average demand outpaces average supply. When the need for commodities or services rises during periods of scarcity, it fuels economy-wide prices to rise, resulting in inflation.

  • Built-in inflation

Built-in inflation occurs when workers demand higher salaries to combat rising living costs. It can create a feedback effect for companies to raise prices continuously to meet the increasing labor cost.

  • Cost-push inflation

Cost-push inflation begins when production expenses raise for companies to make the same goods. Due to more significant fees, market prices rise to follow the increased input cost. Rising commodity prices are an example of cost-push inflation.

They all have similar impacts but also vary in some details.

Can We Control Inflation?

Central banks like the U.S. Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan attempt to manage inflation by regulating the pace of economic activity. 

They can implement contractionary policies that rein an aggregate demand, often by increasing and short-term raising interest rates. The more credibility the central bank has, the greater the effect of its pronouncements on inflation expectations.

Money supply management by central banks in their home regions is known as monetary policy. 

Increasing and decreasing fixed interest rates is the most common way of implementing monetary policy. High taxation declines the availability of spendable funds, lowers real income, and restricts money circulation, preventing higher inflation.

The Federal Reserve sets an inflation target of around 2%, considered healthy core inflation, which takes out the effect of food and energy prices. The central bank wishes for a little inflation, leading people to believe prices will continue rising.

factors that influence inflation

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Positive Effects of Inflation

A sharp price spike erodes the purchasing power, devalues currency, and triggers an economic downturn; some effects of inflation might be beneficial. Let’s discuss the positive impact it has on economic activity.

Increase in Asset Prices

When we look at history, asset prices increased more rapidly than inflation. For instance, long-term house prices have surpassed inflation. 

In the 1980s in the US, the average house sold was $74,500. When we adjust that sum for inflation, it’s around $231,000. For comparison, in 2021, the average house sales were $453,700. It increased by $379,200 in 41 years, which is more than a significant gain.

The impact of inflation on the stock market is another significant example. It has returned an average return of 10% per year since the S&P 500 in 1926. If we account for inflation, the market has an inflation rate return of over 7%.

However, it is a different situation regarding high inflation (above 2% of the consumer price index). Growth stocks tend to be more expensive and don’t respond well to inflation. It discounts the present value of their future cash flows more heavily. In the past, during high or rising inflation episodes, technology and consumer stocks have lagged.

Expanded Investment and Spending

Consumers are motivated to move purchasing decisions forward as inflation increases.

Because people expect inflation, they rationally decide to buy some product now rather than wait until next year and pay more. It refers to things like new fridges, cars, phones, laptops, and other consumer goods.

Still, this expands over consumer goods. People are looking to find the best way to invest. Investing is necessary because it is the only way to maintain the same purchasing power as the money starts losing its power under inflation.

Let’s say you have $1,000 in the bank and earn interest of 1 percent. But, if inflation is consistently at 3%, you will lose money year after year. You have two ways to react in this situation.

First, you can take inflation to take hold and see the value of their money decline. Or, a better option, try to find higher-yielding investments. This can also benefit the economy because people who save are looking to move their money to more productive areas of the economy.

On the other hand, this can be a potential inflation risk because the average consumer may not have enough skills or knowledge to make a good investment. In addition, there is a considerable potential risk of economic loss because of poor money management.

Decrease an Effective Level of Debt

People with high levels of debt may benefit when inflation rises, whether they are consumers, businesses, or the government. 

Let’s illustrate: if the borrower has a debt with a 2% of interest rate and the inflation rate is at 10%, their income increases at a similar rate. That means the effective rate by which they are repaying declines.

So, this can be beneficial for people in debt. However, it’s not the same for individuals such as savers and institutions such as central banks. For them, it can be an enormous disadvantage.

Banks can lose out because they get lower interest rates than the inflation rate. And savers are probably earning interest below the inflation rate.

Year-over-year percentage change in US inflation

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Better Alternative Than Deflation

Deflation is a term that refers to a general decline in prices for goods and services. It is usually associated with diminishing the supply of money and credit in the economy.

During the period of deflation, the purchasing power of money rises over time. So, deflation is why the nominal costs of capital, labor costs, goods, and services fall. 

For example, during the global financial crisis in 2007, when they tried to prevent deflation, the U.S. Federal Reserve and other banks kept interest rates low for a prolonged period. They instituted different types of monetary policy to secure financial systems with plenty of liquidity.

Even though there are many arguments over inflation, for example, what is the most optimal rate, a consensus between economists is that inflation is better than deflation. Economists hold that deflation is more harmful to an economy than inflation.

During deflation, consumers might benefit because of the overall drop in prices. However, deflation has the power to increase the debt burden on everyone – governments, individuals, and private businesses. 

Due to this, deflation can effectively paralyze public services and create a significant number of bankruptcies as companies cannot meet repayments that are efficiently becoming more expensive.

effects of inflation

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Negative Effects of Inflation

Even though high inflation can help stimulate economic activity, too much can destroy it. How does high inflation negatively affect our economy? Keep reading to find out!

Disparity Between People

Inflation significantly impacts low-income households. Those people spend the majority of their income on monthly expenses. When the price increases, they usually spend all of their earnings.

Obviously, even when food and housing prices rise, we don’t have any other option than to pay. If weekly expenses for groceries increase by $10, it has a more profound impact on someone earning $11,000 a year than someone on $55,000.

We already talked about the effects that inflation has on asset prices. Since assets like housing, and commodities, the stock market tend to beat inflation.

Because of all of that, inflation incentives inequality between people. Wealthier households have more assets, property, shares, etc.

It means that when inflation comes, these assets raise the price of ordinary groceries like milk, bread, eggs, etc. As a result, people with assets have more wealth that can buy them more goods and services than previously. Meanwhile, lower-income people are forced to spend more to get by.

Those with lower earnings tend to spend most of their incomes; therefore, they have nothing or little left to save and invest. Additionally, those people are unlikely to afford a house or other high capital expenditures.

measures of underlying inflation

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Exchange Rate Fluctuations

Expansion in Money Supply

When money supply and prices rise, a country’s currency can decrease. 

For instance, if $1 million is in circulation in the USA and YEN30 million in China, an exchange rate of 1:30. But if the Federal Reserve creates a further $1 million, which takes the total to $2 million, the ratio will decrease to 1:15. It’s a symbolic exchange of markets fluctuate daily.

However, the premise stays the same – when prices increase, and the money supply expands, its value against other currencies declines. 

For example, the lowering of interest rates by the US Federal Reserve in 2021 increased the money supply leading to a higher cost of goods and services.

Exchange Rate Decrease Causes Inflation

Most experts think there is a close connection between inflation and the exchange rate. But that doesn’t mean inflation necessarily causes the exchange rate to fluctuate. 

Usually, inflation results from other causes that contribute to exchange rate fluctuations. Simply put, a decrease in the exchange rate causes inflation rather than vice versa.

A rise in the money supply can lead to inflation and decrease the exchange rate; a fall in the exchange rate can create cost-push inflation. It means that where the price hikes of necessary goods rise as the domestic currency can buy fewer goods. This can be caused by the trade deficit, poor economic performance, or high-interest rates.

The Downturn in Money Value

Money loses its value as the prices of goods and services go up. We always say this is one of the top reasons you should invest. 

If you save your money in the bank account or cash under your bed, it will not be the same in future years. This means you will not be able to buy as much as you could today.

For example, let’s compare the value of the US dollar between 1980 and today. The dollar has lost over half of its value. In other words, if you just stash your money in the 1980s, now you can buy only half as many products as you could back then.

One of the results of loss in purchasing power, inflation, provokes people to try and find a return on their capital. Instead of stashing money under the bed or in low-interest bank accounts, people are more motivated to find better returns. Fear that the saved money over the years will become worthless is a solid reason to invest.

Simultaneously, businesses also feel tremendous pressure to invest any excess capital. Thus, it loses its value if the money isn’t employed in some fashion.

inflation sticker price shock

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Raise in Cost of Living

Real income is a proxy for the standard of living. When real incomes are rising, so is the standard of living and the other way around. Because during high inflation, prices of products increase, it’s needles to say that people will have to pay more to buy necessities and luxuries.

This wouldn’t be a problem if the earnings rose in line with inflation, but unfortunately, it’s not always the case. So, people with the same income but higher prices on products will have to spend a higher percentage of their money to cover their basic needs. 

People are slowly anticipating higher prices, though long-term inflation expectations have yet to jump drastically higher.

Another thing inflation does pushing taxpayers up into higher tax brackets. It means significantly raising taxes for some people. When the brackets aren’t correctly adjusted to the current situation; as a result, they end up worse off.

People with low skills are also affected as their wages are incredibly sticky due to the high level of competition in the market. Many workers are competing for employment which means the employers have more power. 

In proper sequence, wages can slow the rest of the economy, which makes them even worse off. Further, the minimum wage price spiral rises do not always follow inflation, which puts further downward pressure on earnings.

impact of inflation on firms

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Effects on Cost of Borrowing

Let’s say you take out a mortgage for $200,000. You must pay that sum plus interest in 25 years with a fixed rate mortgage. If the interest rate is 5%, the total cost after 25 years will be over $345,000. It means that over $145,000 is interest costs alone.

However, when we look at inflation from the last 25 years (1997-2022), the actual cost is $205,000. In 2022 prices, the total cost of $345,000 is equal to $205,000 in 1997. Even though we see excessive money to pay back, inflation can reduce costs.

Therefore, the borrowed money is worth less year after year. Due to that reason, the debtor has to provide fewer resources to pay off their debt. 

For example, a debtor may earn $25,000 per year after tax. They also take a $50,000 loan equivalent to 2 years of income. But, after five years, inflation has taken their pay to $50,000, which is now equal to 1 year’s wage.

That being said, constant and high inflation levels might prompt financial institutions to raise their rates to protect themselves from inflationary pressures. In turn, people with debt may find it more complicated to obtain credit.

How to Protect Your Finances?

After all this reasoning, one thing is clear: we must invest our money to beat inflation and protect ourselves. One million dollar question is: where to invest?

Most people choose traditional options like buying gold or other precious metals; some decide to go with stocks, real estate, or others. However, they all have something in common – they are all risky, and the difference is the degree of risk. For example, many experts debate whether high inflation hurts or helps stocks overall.

We are happy to represent the ultimate way to invest during inflation without risk – the Infinite Banking Concept. While traditional assets may fluctuate during economic turmoil, the Infinite Banking Concept can offset inflation expectations.

Infinite Banking Concept

Infinite Banking Concept, also known as over-funded life insurance, is a process that strategically uses a person’s whole life insurance policy. Let’s break this down.

A whole life insurance policy is a type of permanent life insurance coverage that provides death benefit protection and a cash value component. The funds in the cash account are growing on a tax-deferred basis, meaning there is no tax due on the gain unless or until it is withdrawn.

With a whole life policy, the initial amount of the death benefit and the premium are fixed income. Over time, provided that the policyholder is still living, the policy will become paid up, and premiums are no longer due.

A founder of Infinite Banking Concept, Nelson Nash, knew that whole life would be a fantastic asset during inflation. He said, “whole life insurance built this away [for Infinite Banking Concept] is a natural hedge against inflation.”

How? With the Infinite Banking Concept, we control entirely accumulating capital in an asset. This process is straightforward. 

You take a low-interest loan from a mutual insurance company and draw money when needed. You are also in control of spending – there are no rules on how you should spend your money.

So, after taking a loan, instead of paying high interest to a bank or other lender, you pay off yourself. Because of this, the Infinite Banking Concept is often called the process of becoming your own banker.

And it’s true to the point because it’s designed to copy the standard banking process; you’re banking yourself. However, you are getting wealthy instead of traditional banks that profit from loans and interest rates.

Thanks to the whole life policy underlying the Infinite Banking Concept, you provide liquidity, earn stable returns even when inflation rises, and have a safe space to keep your money during inflation. Whole life policies are designed to build cash value through interest and dividends. 

Further, your policy’s cash value continues to grow even when you take a loan. Now you can see why the whole life and Infinite Banking are perfect for beating inflation – each dollar of cash value works twice as hard to combat inflation.

Final Thoughts

Effects of inflation can vary depending on your situation and many other factors. 

After reading this article, we believe you have a better picture of how the period of inflation can impact the global economy and your lifestyle. However, the Infinite Banking Concept is the best way to protect your finances in this period!