#4 The Value of Money: How Inflation Impacts Your Wallet

Congratulations, your boss just called to tell you that your salary just doubled. Awesome, huh? Imagine all the extra stuff you can now afford from on day to another. But wait, what if everyone else's income also doubles? Suddenly, your newfound wealth won't stretch as far, because there's now twice as much money chasing the same amount of goods. And if everyone else's income triples while yours only doubles? You'll actually be worse off, as the overall increase in prices will outpace your increase in income. Inflation is a harsh reality of economics, with history showing us that a dollar today can buy you only a fraction of what it could 100 years ago. So, while a higher income is great, it's important to make sure it keeps pace with the rising cost of living.

Inflation is a hot topic these days, with everyone from your grandma to your stockbroker talking about it. But what is it, exactly?

Simply put, inflation is when the price of goods and services goes up over time. But why does this happen and why is it causing such a fuss? Let's dive right in.

The root cause of inflation is simple economics. When there's more money(demand) in the economy than there is stuff to spend it on(supply), the value of money(purchasing power) decreases and prices go up.

Now, why is there more money in the economy in the first place? There are several reasons, but one of the biggest is when the government decides to print more money. This can be a positive factor if it helps stimulate the economy and create jobs, but it can also lead to inflation if the government goes too far.

I grew up in a little town in the middle of western Bohemia with pretty much a single market where people could go to buy their necessities. Let’s use that as an example of how inflation impacts the real world. In this example, to stimulate the economy and make it easier for people to take out loans, the government decides to lower interest rates and on top of that drops off a pile of cash for everyone in the village in form of a stimulus check. The people in town now have more money to spend, causing demand for goods at our local market to skyrocket. With limited supply, the market owner has to raise prices to keep up with demand and that results in inflation. So in simple terms, too much money chasing too few goods leads to higher prices.

Just as the village represents all of us, the society, the market symbolizes the whole economy. When there is an excess of money circulating and people are eager to spend it faster than businesses can produce goods, the prices of all businesses across various industries will rise and that will cause inflation, which is a standard part of the economic cycle and in moderation it is perceived as a positive development as it indicates growth.

Getting back to our little town example - As the demand continues to rise, the market's prices for goods keep growing. The business is good and when combined with a low interest rate on capital, the store owner makes the move to expand his business by opening a bakery right next to his market, which is positive for business growth in the area.

However sooner or later the government money dries up while the market prices remain high, so there are no longer any customers who want to purchase his goods for that price. On top of that the owner now has a new bakery and more employees, but no one to buy his products. This forces him to close down the bakery, lay off employees, and gradually decrease his prices. That is known as a recession.

During COVID we’ve seen massive waves of financial aid in form of stimulus money to keep the economy pumping. Huge part of this stimulus was newly printed money that flooded the market and created huge increase in demand for the goods in the economy. At the same time we witnessed an enormous supply chain crisis at global scale that crippled supply around the globe and the combination of these two factors created a substantial imbalance in the world economic markets.

As a result people had more money than usual and were eager to spend it, but the economy couldn't supply goods fast enough.

So what options do we have in fighting the current situation and what do interest rates have to do with everything? Most countries have a central bank that is the backbone of their economy and functions as the regulator for all the local banks. Unlike a traditional private bank, the central bank is run by the government, is not driven by profit and its main objective is to monitor and control the economy to ensure stability, employment and consistent growth.

The central bank can be seen as a puppet master that manipulates the economy by affecting how people spend their money, which in turn affects the supply-demand scale and business pricing. It works by controlling interest rates, which is one of the tools they use to influence spending. For example, when interest rates are low, people and businesses are more likely to borrow and spend money. During the pandemic, the central bank lowered interest rates to encourage spending and was successful, however now as the result, there is too much money circulating and not enough goods and services to go around, causing businesses to raise their prices to meet the demand. This leads to a decrease in the value of money, causing further inflation.

So there it is. The current inflation situation is a complex dance between the central bank, businesses, and consumers. But despite the complexities, the underlying message is clear - your money is only worth as much as what you can buy with it. And when prices start to rise faster than your income, it can feel like the ground is slipping beneath your feet. However, by understanding the role of the central bank and how they use interest rates to manage the economy, we can see that there are forces at work behind the scenes to keep the economy stable and growing. So the next time you hear about inflation, just remember that you're not alone in feeling the squeeze - it's a universal experience that affects us all and we are all in this together.