The Philippine Online Chronicles

What is inflation?

Inflation, by definition, is the loss of purchasing power of a currency. In layman's terms, it is equivalent to an increase in the price of a commodity over a certain period of time. The easiest way to illustrate inflation is by an example. Suppose one can buy a piece of siopao for P80 this year and the yearly inflation is 10 percent.

In theory, 10 percent inflation means that next year the same siopao will cost 10 percent more or P88. So, if one’s income does not increase by at least the inflation rate, he will not be able to afford to buy as many pieces of siopao as before. However, a one-time price increase due to new taxation or oil price hike does not represent inflation, unless it causes a chain reaction that leads to wage increase that in turn increases commodity price further.

What causes inflation?

There are different factors that affect the cost of a commodity. The common causes are:

• Supply and demand. It is common to see prices rise because of low supply and high demand for a commodity. When the supply of basic needs is low, storeowners react by hoarding. The effect on the market is an upward adjustment of price. The stores sell at a wide profit. The opposite happens when the supply is more than the demand. With money, when the government prints more money than what is demanded in circulation, inflation occurs. As a result, commodity price increase at a high speed to keep up with the currency surplus.
• Rise in production cost. An example is oil. When OPEC raises oil prices, all industries depending on oil will pass the additional cost on their produce to the consumers. When prices increase, workers demand a wage increase. If the government approves it, the additional labor cost will be imputed again to the products, thus creating a never-ending chicken-and-egg cycle of price escalation that leads to inflation.
• Foreign currency fluctuation. As countries trade products, the accepted universal currency of payment is the US Dollar (as of now it is the universal currency. Like the British Pound, which was replaced by the US Dollar after the war, there is a move by countries to shift to Euro). Any instantaneous change in the conversion will affect the price of import. A slide in the value of the dollar will hurt the importer. Since all countries peg their currency to the dollar, the importer needs to have more dollars to purchase the same item than before. The exporter will be happy since he earns more dollars. To illustrate, please refer to the table below:

We can see that the importer will have to increase his selling price to cope with the cost of buying more dollars to buy the same product. That is the reason we often hear importers complain of loss whenever the dollar depreciates. Ever wonder why there is a saying “When America sneezes, the world catches cold”? Whatever happens to the dollar will surely affect other countries, since all currencies are pegged to the dollar.

• Taxes. Taxes are expenses by the government passed on to all companies and every individual. Taxes are added to commodities, thereby raising the price. An example is 12 percent VAT. Aside from the income tax that we pay, whenever we make purchases, we pay additional 12 percent tax. When there is a new tax proposed, it means that the government spends too much compared to its income, or that corruption is rampant to the point that more taxes need to be collected. A solution is to print more money; however, greater money supply decreases the value of money due to abundance, resulting in inflation.

How does inflation affect my investing?

The purpose of investing money, in general, is to grow money. Investing is simply letting money work to produce more money. In investing, there are risks involved. One of them is inflation. Inflation, if left unchecked, will eat up gains made in any investment. As a rule, if one invests, he should make it a point to outpace inflation, or else he will not realize his financial goal. Let us say inflation is 10 percent and a person’s investment yielded 8 percent return. In effect, inflation caused his money to lose 2 percent value. He will not be able to buy items that rose by 10 percent. If the price rose by ten pesos, his money only earned eight pesos. In order for him to maintain his money’s purchasing power, he needs to put his money where it can earn 10 percent or more.

How to counter inflation?

What are the means and vehicles to fight inflation? There are a variety of investment vehicles that can match one’s goals but also carry certain risks. Examples are real estate, mutual funds, old pre-need plans, treasury bills, bonds, insurances, stocks and franchises. Some features of these vehicles are cost averaging, leverage, long term growth, risk and wealth transfer. The only requirement here is before investing, one should investigate first. One should study and learn the various ways of minimizing inflation to grow wealth. One should determine his risk appetite to be able to determine what kind of vehicle to take in relation to his financial goals. The most important thing of all is education and information before one decides to invest. Always bear in mind the saying “If education is expensive, try ignorance.”

Image: Child in a balloon-inflating contest. Licensed under Creative Commons Some rights reserved by peruisay.