Explaining Inflation; And Why Small Price Increases Are Better Than Price Decreases

Explaining Inflation; And Why Small Price Increases Are Better Than Price Decreases.
Since a common objective when investing is to beat the inflation rate, it's become a topic that I've been quite curious about. So I've decided to do some research on this.

And for a year now, the inflation rate has either gone down or stayed relatively low. Since 2012 started, it hasn't hit 4% and has stayed around 3%.

And not surprisingly, it's been touted by the government and by the Bangko Sentral as good news. However, when people hear the news the common response goes something like this: "So why can't we feel it?"

And the simple answer is: because we're not supposed to.

For the more detailed answer, we'd have to revisit what inflation rate is: Inflation rate is the rate at which prices have increased in the last year.

And that's the primary reason we don't feel a "good" inflation rate: prices still went up. So how can that be good news? Wouldn't it be better if prices went down?

Well, to examine further why we consider low inflation rate good news we'd have to examine three main ways it could go: High (typically around 5% or more), low, or negative (a.k.a. deflation, or the time when prices are falling).

Obviously a high inflation rate is bad news. Unless our incomes are increasing at the same rate, it won't be long before we can't afford basic necessities like food, transport or rent.

So how come we treat low inflation as good news? Shouldn't lower prices be good news?

Well, this is where it gets tricky. Normally lower prices would be good news. But the rise in prices can actually be good for us. Let's use ice cream to illustrate.

If we work for an ice cream factory, and we've done great work, at some point we would deserve a raise. It could be because we got promoted or because we've done such great work that they want to pay us more so we don't work for someone else. So the company takes some of their profit and allots it for our salary increase. But what if there's a hundred of us who deserve a promotion or raise? The company will take a chunk of their profit and give it to us.

And to make sure everyone is happy (and therefore productive; making the company profitable), the company might also give us other benefits like health insurance, company-sponsored team buildings or holiday parties, bonuses, and other stuff.

At first, the company can pay for all of those by selling more ice cream. They might even lower prices a little bit so more people can afford and buy ice cream.

But after a while, everyone would already be buying ice cream. And the company would have to raise prices so they can keep paying for our salaries.

Alternatively, let's consider a different option. Let's imagine everyone works in an ice cream factory. And we all have the same salary. But someone came up with frozen yogurt. And since we all work in an ice cream factory, most might prefer to eat frozen yogurt instead of ice cream. But there's only so much frozen yogurt to go around. And because the demand is greater than the supply, the price will naturally rise.

And the frozen yogurt guys will then use the money to put up more stores, pay overtime, and hire more workers. And they will offer better salaries to entice workers, since everyone else works for the ice cream factory. And we (ice cream factory workers), because the price of yogurt is high, will switch companies and work in the frozen yogurt factory so we can have more money to buy frozen yogurt.

So rising prices, despite being a burden, also benefits us (although in a roundabout sort of way). But what if prices get lower and deflation happens?

There are several reasons for prices to get lower: competition, streamlining, more cost-effective processes or raw materials, etc. But deflation means prices overall are going down. That sounds like a good thing. But if companies are making less or no profit, they have less money to pay their employees. So it's either pay cuts or layoffs. And people with less or no income also spend less. With no one buying ice cream or yogurt, it just gets worse.

So that's essentially why we don't feel the effects of a "good" inflation. We'll only feel it if it's very high or negative (and begins to affect incomes).

In my next article, we'll try to find out more practical benefits of having low inflation rates.


If you liked this article, please subscribe to The Personal Finance Apprentice or follow us on twitter and facebook.


photo credit: Stitch via photopin cc

No comments:

Post a Comment