For many people, trying to understand how the economy works can be complex and confusing. Hearing terms such as gross domestic product, consumer price index or the now infamous “junk status” can be challenging for many people, without having a basic understanding of how these factors affect them personally on a day-to-day basis.
An important economic factor to understand is inflation.
Why It’s Important to Understand Inflation and How It Affects You
Inflation is a sustained rise in overall price levels. It affects all aspects of the economy, for instance: consumer spending, business investment, tax policies and interest rates.
As a consumer, there are various factors that influence how much money you have to spend. At a basic level, if you need something, you are likely to spend a certain amount of money to fulfil that need. But when your spending power is reduced as a result of rising inflation, you may start cutting back on other spending.
An indicator used to measure inflation is generally the Consumer Price Index (CPI), which reflects retail prices of goods and services.
At a broader level, inflation is important to understand because it can reduce the value of investment returns. Inflation affects investment returns by chipping away at real savings and investment returns.
There are Two Types of Inflation
- Cost- push inflation – affected by commodity prices.
- Demand pull inflation- when demand outstrips supply, leading to an increase in prices.
As economic growth picks up, inflation generally increases. As a way of controlling inflation to a certain extent, central banks either raise or lower short-term interest rates. This is known as monetary policy.
Another way inflation can be controlled is through fiscal policy – controlled by government.
Having a working understanding of how inflation affects you is important as a citizen. Not only is it an indicator of the country’s economic growth, but it’s also a handy tool for working out how much you can truly afford to spend every month.