Inflation: What is it, what causes it and how does it impact us?

Sketchnote explaining what inflation is, some common causes of inflation and how inflation impact us. Full text description below.

It seems like everyone is talking about inflation these days, but what actually is inflation and how does it impact us?

What is inflation?

Inflation is when the price of goods and services go up, while the value of our money goes down. This means we are getting less for our money, which explains why things feel more expensive.

Common causes

There are lots of causes of inflation and many of them are completely out of our control.

One common culprit is when a government ‘prints money’ faster than the economy is growing. With lots of additional money sloshing about in the economy, the value of the currency (eg GBP, Euros, Dollars) drops making it more expensive to buy imported goods, resulting in consumers paying more for the same amount.

Governments print excess money for lots of reasons, but one of the key motivators is to help pay down national debts and as we’ll see in a bit, the drop in the value of the currency also results in a drop in the value of the debt.

Another factor influencing inflation is when demand for goods and services is higher than supply, which means more people want things that are becoming less available. At the time of writing we’re entering an energy crisis. With supplies of gas being limited below demand, the result is energy bills for businesses and consumers going up.

To cover their extra energy costs, businesses have to put the prices of their goods and services up, which means things cost even more to consumers.

On their own, neither of these factors will be solely responsible for a rise in inflation, however it is the complex combination of these and many other similar factors that drive prices up and the value of our money down.

The effects of inflation

Aside from the price of beer not being what it was (when I were a lad…), there are many ways inflation affects us. And these vary depending on the rate of inflation.

One interesting effect is the value of debts is reduced by the reduction in the value of the currency. So a government debt of £1bn might end up being the equivalent of £900m after inflation.

When you look at it this way, you can understand the temptation for the government to keep printing excess money. Not only do they rely less on tax revenues, they also get the added benefit of the overall debt reducing in value.

With debts becoming less expensive, another effect is an increase in borrowing, spending and investing.

Businesses benefit too. First they are able to borrow and invest more in growth and secondly they can put their prices up due to the extra demand for products and services. 

A further benefit for businesses is wages tend to lag behind inflation, meaning it becomes cheaper to employ people, resulting in lower levels of unemployment.

So what could possibly go wrong?

Well, as we are finding out at the moment, inflation doesn’t impact everyone in the same way. 

For example, homeowners will benefit with the effective value of their mortgages being reduced, while property scarcity continues to drive up the value of their homes. But those wanting to get onto the property ladder will find the prospect of home ownership even more challenging.

Lots of people are also finding their costs of living are going up, but their incomes are not increasing at the same rate.

People with cash savings are finding the value of their savings are effectively dropping, as every £1 they have will now will only enable them to buy something with an equivalent value of 90p (not an official figure – just an example).

Excessive government borrowing increases the national debt and raises the credit risk, which leads to more expensive interest rates on the debt in the future. Government cutbacks to reduce national debts leads to a decline in public services and help for those most in need.

The worst case scenario

The ideal situation for a government economist is probably a consistently mild level of inflation (1% or 2% max) over a prolonged period of time.

This helps keep national debts under control and drives a sufficient level of growth, which maintains lifestyles that keep the voters relatively happy.

What economists fear however is this pleasant little kees-up turning into a rowdy bar brawl where inflation rises completely out of control.

The absolute worst case scenario is hyperinflation, where the printing of money turns into a vicious cycle of rising prices, resulting in greater money printing, resulting in rising prices, etc, etc.

The Weimar Republic hyperinflation of the 1920s is perhaps the best known example of this, where people had to take a wheelbarrow filled with cash to the shops just to buy a loaf of bread. The most recent case was Zimbabwe in 2008.

Getting it just right

There is an ongoing balancing act between inflation and deflation. Too much deflation and you risk falling into economic depression. Too much inflation and you risk the economy overheating. At extremes, both lead to difficult social and political problems.

The ideal balance is said to be a consistently low level of inflation which keeps things ticking over just nicely.

Sounds easy enough in principle, but we have to remember the economy is a hugely complex and uncontrollable system.

People might claim to be able to control the economy, but in reality they can only influence it through policies and interest rate changes and without wanting to wander into a political minefield, no single policy will ever solve this unsolvable economic riddle or win universal approval among voters.

Thanks for reading 🙂