Inflation and Recession are the two terms that most of us have heard being thrown around by economic experts when talking about the overall economic health of the country. While we often heard that inflation and recession are not good for us, do you know how they really affect us? In this article, we will talk about inflation and recession and how they affect us.
But before we begin, let’s try and understand what inflation and recession mean.
Inflation is a steady rise in prices of goods and services in an economy over a period of time. When prices rise, every single unit of the currency purchases lesser products and/or services. Therefore, inflation reflects the purchasing power of one unit of money. Moderate inflation is good for the economy as it is associated with economic growth. High inflation is usually the sign of an overheated economy.
Usually, as the economy grows, people spend more money on products and services. In other words, when the economy grows, the demand is more than the supply of goods/services resulting in an increase in prices. This leads to an increase in the inflation rate. However, if the economy grows too fast, the demand grows faster leading to rapidly increasing prices.
On the other hand, when the economic growth slows down, the supply of goods/services is proportionate to the demand and the inflation rate drops. This is called disinflation.
A recession is a general slowdown in the overall economic activity and is registered as a drop in GDP. Among other reasons, inflation is one of the major causes of a recession. During inflation, the input costs increase for the businesses as well. Therefore, businesses pull the brakes on production, cut down on salaries, and adopt cost-cutting measures. A prolonged and pronounced recession is called an economic depression.
Usually, a recession happens when majority people in an economy reduce spending. There are various factors which can trigger an overall reduction in spending like high-interest rates, reduced wages, and above all inflation.
How do inflation and recession affect us?
Here are some ways in which inflation and recession directly affect us:
Reduces Purchasing Power
Inflation reduces the purchasing power of currency due to a rise in prices across all products/services across the economy. Since inflation is an increase in prices across a basket of products and services, if the income levels do not increase with the same rate, our purchasing power will diminish meaning we will be able to buy less
Encourages us to spend and invest more
When the prices are constantly rising, people tend to buy now rather than later, since money will lose its value. Therefore, during inflation, people tend to buy and stock up on things as far as possible. So, consumers tend to fill up their gas tanks, stuff food in the freezer, etc. and buy assets like gold and other precious metals. Businesses, on the other hand, make capital investments. Overall, people tend to invest in an inflated economy so that they can earn enough returns to beat inflation corroding their savings in the long-term. This usually happens early in the expansion cycle when inflation is rising due to the lower interest rate. People are encouraged to spend rather than save. When inflation heats up and the interest rate rises the spending will reduce as people will be encouraged to save. The interest rate is a tool often used by central banks to manage the inflation rate among other things.
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Increases Borrowing Costs
Early in the expanding economic cycle interest rate will usually be low. This is to encourage people to borrow and spend and for businesses to borrow to invest in the business. However, when the economy overheats and inflation starts rising rapidly the interest rates rise to control the inflation which will increase the borrowing costs for people and business discouraging the spend and save more.
Increases the employment levels
With increasing prices, being on a job with a lower salary is better than being unemployed. Therefore, people accept jobs and work harder to manage the costs. This leads to a decrease in unemployment levels in the economy. Also, as the unemployment levels fall, employers are forced to pay higher wages for skilled workers. Therefore, wages start increasing and inflation increases further.
Eats into your long-term savings
If you are someone who believes in conservative investments, then inflation can be a problem. This is because conservative investments usually require investors to lock-in their investments for a really long time and inflation can create a situation where your long-term investments earn returns which are lower than the increased prices due to inflation. If the inflation rate is higher than the savings rate you are earning, in real terms you are losing money. This is because the prices of products and services are rising faster than your savings.
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Inflation is an indicator of a healthy economy. It is more like a cycle – inflation leads to the growth of the economy, which increases employment and leads to higher wages and more money in the pocket of regular people. This eventually leads to more goods and services being purchased, keeping the economy healthy. So, while inflation can make things costlier, a controlled rate of inflation can help the economy grow.