The Goldilocks Zone of Inflation: Finding the Sweet Spot

Understanding Inflation: How it Affects You and Your Money

Today, we’re going to discuss inflation and how it affects the economy. More importantly, we’re going to talk about how inflation affects you and your money within the economy. 

Inflation is a term often heard, but rarely understood. Most people associate inflation with price increases and a decrease in the purchasing power of their money. However, inflation is a complex economic concept that has both positive and negative effects. Hopefully, by the end of this article, you’ll have a better understanding of inflation, how to use it to your advantage, and what you can do to protect your finances.

What is Inflation?

Inflation is defined as the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. This means that the same amount of money can purchase fewer goods and services over time.

There are two main causes of inflation: 

1. Supply Chain Disruptions: Supply chain disruptions occur when there is a scarcity of goods and services, resulting in high demand and increased prices. 
2. Monetary Changes: Monetary changes occur when there is an increase in the money supply. This results in a decrease in the value of money and, subsequently, an increase in prices.

Why is inflation necessary?

At first sight, inflation just seems inherently bad, evil, and wrong. However, the key to understanding inflation is that it's like Goldilocks; it needs to be just right. You don't want too much, but you also don't want too little because the opposite side of inflation is deflation, which means that prices, in particular, assets, start dropping.

The government printing trillions of dollars is the primary cause of inflation, but this was necessary. With the COVID-19 pandemic, the government had to print money to bail out companies and make sure that people didn't go bankrupt or lose their houses. The government also had to make sure that people could stay at home and stop working to prevent the spread of the virus. This caused a massive labor shortage, and many people have yet to return to the workforce. This is a problem when it comes to the delivery of supplies and goods because the labor force isn't there to make sure the goods and services can be delivered.

This increase in demand, coupled with scarcity, made the prices of goods and services explode. In the 1970s and 1980s, we saw inflation rates of over 12 percent. However, since the 1990s, we haven't seen inflation over five percent. But the last few months have seen inflation spike, and it's now over five percent.

The Impact of Inflation and How Paul Volcker's Monetary Policy Curbed It

As stated, during the 1970s and 1980s, inflation rates skyrocketed to over 12 percent, and the government was unsure of what actions to take. However, Paul Volcker, who was the Fed Chair at that time, came up with a solution. He decided to allow interest rates to rise, which gets to the heart of what inflation is and how the government stops or creates it through monetary policy. The government has the power to print money and change the money supply, and when interest rates increase, money contracts, and people cannot buy as much because borrowing becomes expensive. This causes the amount of money in the economy to shrink, which is what Volcker did to cure massive inflation. 

Although it sent the economy into a recession, he successfully reduced inflation to a reasonable level that has not exceeded five percent since the 1990s. However, in the last few months, inflation has spiked due to the increase in the money supply in the economy and the breakdown of supply chains. Inflation is particularly bad for the middle and lower class because it reduces their disposable income and purchasing power, which can cause concern and uncertainty among people.

Protecting Your Finances During Inflation

Inflation can have a significant impact on your finances. As prices increase, the purchasing power of your money decreases, which can make it more challenging to maintain your standard of living. There are several steps you can take to protect your finances during inflation.

First, it is important to invest in assets that have a high rate of return. Assets such as stocks, real estate, and commodities tend to increase in value during inflation, which can help offset the decrease in the purchasing power of your money.

Second, it is essential to reduce your debt burden. Inflation can make it more challenging to pay off debts, as the value of the debt decreases over time. By reducing your debt burden, you can free up more money to invest in assets that will appreciate in value during inflation.

Third, it is important to maintain a diversified portfolio. Investing in a variety of assets can help reduce your risk and increase your chances of earning a high rate of return during inflation.

The Goldilocks Zone of Inflation

The government has a target rate of inflation of around 2.5%. Right now, we are much higher than 2.5%, and you've probably noticed that the stock market and housing prices are rising. When there's an influx of money into the economy, inflation affects assets and makes them rise, which makes a lot of people very wealthy. To understand how inflation makes people wealthy, we have to understand the movement of money around the economy.

How Inflation Makes People Wealthy

Inflation erodes the purchasing power or value of your money. Having your money sit in the bank while there's 5% inflation is a guaranteed 5% loss every year. That's why you used to be able to buy candy with a penny, but you can't buy candy with a penny anymore because the penny is worth nothing. People have to find somewhere to put their money to protect it from losing its value. This is key to understanding the incentives within the economy.

The Government's Incentives

The government incentivizes people to spend, buy, borrow, and invest their money. Money starts to flow into places like the stock market, which historically has returned an average of around 9% over the last 100 years. In the last 10 years alone, the stock market has returned over 13%. Money is also flowing into hard assets like real estate.

Influx of Money into the Economy and Asset Prices

Now, let's talk about how inflation affects asset prices. When we have an influx of money injected into the economy, why does inflation affect assets and make assets rise? It's because inflation erodes away the purchasing power or the value of your money. Having your money sit in the bank with 5 percent inflation is a guaranteed 5 percent loss every single year. That's why you used to be able to buy candy with a penny, but you can't buy candy with a penny anymore because the penny's worth nothing.

People have to find somewhere to put their money and protect it from losing its value. This is key to understanding the incentives within the economy, and that's what the government is doing. They incentivize people as to where to put their money. They are incentivizing people to spend it, to buy, to borrow, to invest it, so money starts to flow into places like the stock market.

Finally, inflation is a complex economic concept that can have both positive and negative effects on the economy and individuals' finances. While inflation can boost economic growth, reduce debt burdens, and increase asset prices, it can also decrease consumer purchasing power, lead to job losses, and negatively impact foreign investment. To protect finances during inflation, individuals should invest in high-return assets, reduce debt burdens, and maintain a diversified portfolio. Moreover, moderate inflation is necessary for the government to manage its debt and deficit. Overall, understanding inflation and its impact on the economy and personal finances is crucial for making informed decisions about investments and financial planning.

Hopefully, you’ve arrived at a better understanding of inflation, how it works, and how it affects your personal financial security. By utilizing the systems available to you, and increasing your knowledge of how money works in relation to inflation, you can maximize your money’s value and ensure long term financial freedom.