How does inflation affect the economy?

How does inflation affect the economy?

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When people Google this question, what they are really asking is, ‘how does inflation affect me?’

The short answer is that it makes the things you buy more expensive. But, this only really tells one part of the story. In fact, inflation’s effects can be wide-ranging and specific to your own circumstances, including what you do for a living, and where you live.

Boiled right down, inflation is the change in cost of everything in the huge imaginary shopping basket of annual purchases that are used to calculate the Consumer Price Index (CPI), from which inflation is derived. It includes everything from a pint of milk, to trainers, petrol, train tickets and even your rent or mortgage and energy bills – around 700 items in total, representing the purchase habits of 66 million Brits. In normal circumstances the CPI rises each year by about two or three percent. Not so much that most people feel an immediate effect, but enough to create a slow annual upward creep in the cost of living, resulting in nostalgic conversations about when a Freddo cost 10p or a can of Coke cost 25p.  

Inflation can also work in your favour.  There are currently not enough software engineers to meet demand of companies scrabbling to join the fourth industrial revolution – digitisation of services into online or app-based ‘always on’ and on-demand. It’s simple supply and demand economics: when demand outweighs supply, prices will typically inflate. As a result, software engineers can currently command huge salaries. Good news for them.

But, let’s consider the other effects. Tech companies, like many industries, tend to flock together, establishing a sector ‘eco-system’ in a particular town or city. Consequently, house prices in and around these eco-systems start to soar – again, simple supply and demand. Suddenly the software engineer enjoying a highly inflated pay packet finds they need to offer 30% above asking price for a two-bedroom flat in a not-so-up-and-coming part of town.

Assuming they’re willing to pay the premium, this will force others to reconsider where they live. They may figure it’s cheaper to just move further out and get the train. Even this may not save them money. As anyone who commutes by train well knows, annual train fare price rises come into force on 1 January (Happy New Year commuters!) and follow a set formula, rising by the rate of the of Retail Price Index (RPI) plus 1% - typically above the rate of inflation.

Meanwhile, local restauranteurs in this budding tech-hub town realise that there’s a new group of highly affluent professionals to cater for, so they introduce new fine-dining menus and hike their prices. Suddenly you’re paying £50 for a diet coke and a designer salad. The luxurious disposable income our software engineer’s generous salary was affording them is suddenly not stretching so far. Inflation, having given generously with one hand is now taking with the other.

Nowhere else is this being felt as prominently than in savings currently, thanks to persistently low interest rates. No matter what our generously-salaried developer can afford to put aside each month, in a standard cash savings or ISA account it’ll invariably be worth less than it was in a year’s time in real terms unless they’re lucky enough to find a rate of return higher than the rate of inflation.

The problem is, whether you happen to benefit from inflation, or not, no one escapes its negative effects. When inflation gets out of control, it forces people to start making changes to their lifestyle. They stop going out for dinner, travel less, downsize or move to more affordable areas and become more cost-conscious in general. Staycations and nights in front of the TV become the dominant leisure time choices – no small wonder Netflix is fast-approaching 10 million UK subscribers in 2019.

This examination of the effects of inflation would not be complete without a mention for its lesser-known and oft-overlooked sibling, deflation.

Deflation is most commonly associated with depression and recession.  When companies sell their services or products for less than they did the year before, theory follows that workers will get paid less, or even lose their jobs, meaning families have to adjust and cut back.

However, the other side of deflation harks back to the work of our protagonist developer friend, using technology to innovate and disrupt traditional products and services, making them more readily accessible to more people. The resulting deflationary pressure on the price of goods and services means they become available to ever-wider audiences. Now, cars, computers, air travel, mobile phones, even investing, is within reach of the masses.

In a way then, the original question – what does inflation mean for me? – should instead be ‘what has inflation ever done for me?’ Whether you’re a software developer, nurse or astronaut, no-one escapes the negative effects of inflation. Some of us may benefit from its more agreeable effects temporarily or otherwise, but its slow, almost imperceptible effect will always eventually see us reminiscing in years to come about when a Mars Bar ‘only’ cost £1.

 

Please remember the value of your investments can go down as well as up, and you could get back less than invested.

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