Understanding and Beating Inflation: Your Definitive Handbook

Inflation is a continual increase in the general level of prices for goods and services within a specified period in the economy. Essentially, this means, on average, we need more money to buy the same basket of goods and services than before.

This increase in prices reduces the purchasing power of the currency unit, leading to a real devaluation of money. For easy understanding, 10 years ago, the price of a packet of nasi lemak was RM 1.50, and now for the same nasi lemak, it is priced between RM 3.50 to RM 4.50.

Inflation is typically measured using an index, such as the Consumer Price Index (CPI), which tracks the prices of a set of goods and services commonly purchased by consumers. When the CPI increases, it indicates that, on average, the prices of these goods and services are rising, reflecting inflation.

In Malaysia, the basket of goods and services is called the Consumer Price Index (CPI), which is updated weekly on the Department of Statistics Malaysia (DOSM). What items are included in this basket? These include 12 major goods and services.

1. Food and Non-Alcoholic Beverages
2. Alcoholic Drinks and Tobacco
3. Clothing and Footwear
4. Housing, Water, Electricity, Gas, and Other Fuels
5. Furnishings, Household Equipment, and Routine Household Maintenance
6. Health
7. Transport
8. Communication
9. Recreation and Culture Services
10. Education
11. Restaurants and Hotels

CAUSES OF INFLATION?

There are various causes of inflation, including increased demand for goods and services, supply chain disruptions, rising production costs, changes in government policies, and fluctuations in currency value.

Inflation is an important economic indicator, and the central bank often strives to maintain the target inflation rate to ensure price stability and sustainable economic growth. However, excessive inflation can have adverse effects on the economy, impacting consumers, businesses, and overall economic stability.

Inflation occurs due to various economic factors and mechanisms that collectively influence overall price levels in the economy. Understanding these fundamental factors helps demystify why inflation occurs:

1. Demand-Pull Inflation:

One common cause is an excessive demand for goods and services compared to their supply. When demand exceeds supply, businesses often respond by raising prices to balance the market equilibrium.

2. Cost-Push Inflation:

Increases in production costs, such as higher wages, higher raw material prices, or higher taxes, can prompt businesses to pass these additional costs on to consumers through price increases.

3. Monetary Policies:

The actions of the country’s central bank play a crucial role. If the central bank injects more money into the economy (through measures like lowering interest rates or implementing quantitative easing), it boosts the money supply, which can lead to more spending and, ultimately, higher prices.

4. Supply Chain Disruptions:

Events like natural disasters, geopolitical conflicts, or trade disruptions can affect the production and distribution of goods and services. When the supply chain is disrupted, reduced availability of goods can drive price increases.

5. Currency Depreciation:

A depreciation of a country’s currency can result in higher import costs. When a country heavily relies on imported goods, a weak currency can lead to price increases for those imported goods.

6. Expectations and Forecasts:

Consumer and business expectations about future prices can influence current purchasing decisions. If people expect prices to rise, they may buy more now (panic buying), driving higher demand and resulting in price hikes.

7. Structural Inflation:

Sometimes, long-term changes in the economic structure or demographics can lead to sustained price increases. For example, an aging population might increase the demand for healthcare, causing consistent price hikes in healthcare. The same goes for education.

Understanding these basic factors allows policymakers to plan appropriate financial, fiscal, and structural policies to manage and reduce inflation, with the goal of creating a stable economic environment for sustainable growth and prosperity.

WHY DOES INFLATION OCCUR?

Inflation typically occurs during periods of sustained economic growth, where demand for goods and services exceeds the economy’s ability to produce them. There are several common scenarios that lead to the onset of inflation:

1. Economic Expansion: During economic growth and development phases, consumers and businesses tend to spend more. Increased demand for goods and services can lead to price increases as producers try to balance market equilibrium.
2. Loose Monetary Policies: The central bank/Bank Negara Malaysia (BNM) can implement loose monetary policies, like lowering interest rates or injecting money into the economy. This excess liquidity often stimulates spending and borrowing, potentially causing inflationary pressures.
3. Supply Chain Disruptions: Disruptions in the supply chain, whether due to natural disasters, geopolitical tensions, or other factors, can limit the availability of goods and services. Reduced supply along with stable or increasing demand can lead to price hikes.
4. Rising Production Costs: When the costs to produce goods and services increase, businesses may pass these additional costs on to consumers through higher product and service prices, causing inflation. This often occurs with increases in raw material costs or labor costs.
5. Energy Price Increases: Fluctuations in energy prices, especially oil, can have a significant impact on inflation. When energy prices rise, it increases production and transportation costs, affecting prices for various goods and services.
6. Government Fiscal Policies: Government actions, such as increasing public spending or reducing taxes, can inject more money into the economy, stimulating demand and potentially causing inflationary pressures.
7. Expectations and Psychology: Society’s expectations about future price increases can influence buying decisions. If individuals expect prices to rise, they may buy goods and services now, driving higher demand and causing price increases.

It’s important to remember that moderate inflation is considered normal and healthy for an economy, as it signifies economic growth. Central banks often aim to achieve a targeted inflation rate to maintain price stability and encourage sustainable economic development. However, when inflation exceeds a certain level and becomes too rapid or prolonged, it can pose challenges and risks to the economy and its participants.

Which Groups Are Most Affected by Inflation?

Inflation affects various groups in society, but the impact can be different depending on one’s circumstances and economic position. Here are the groups that are often most affected by inflation:

1. Fixed-Income Groups: Individuals and households with fixed incomes, such as salaried workers or retirees relying solely on pensions or fixed annuities, face challenges during inflation. Their purchasing power decreases as prices rise, which can lead to financial strain.
2. Low-Income and Uncertain Income Groups: Those with low incomes are more affected by inflation, as a significant portion of their income is used for basic goods and services. When prices rise, it becomes harder for them to meet basic needs such as food, housing, and healthcare.
3. Savers and Asset Holders: Individuals holding assets with fixed interest rates or returns, such as savings, bonds, or certain types of annuities, may see a real devaluation of their investments due to inflation. Fixed returns may not keep up with the increasing inflation rate.
4. Renters and Home Buyers: Inflation can impact housing costs, including rents and property prices. Renters may face higher rental costs, affecting their disposable income, while potential homebuyers may find it challenging to afford homes due to rising property prices.
5. Debtors and Borrowers: Inflation can benefit those who have borrowed money at a fixed interest rate. As the value of money decreases over time due to inflation, the real burden of repaying loans may decrease. However, this is dependent on the interest rate being lower than the inflation rate.
6. Employees Negotiating Salaries: Employees negotiating salaries during a period of inflation may face challenges in maintaining their purchasing power. They may need to negotiate higher wage increases to keep up with the rising cost of living.
7. Businesses and Producers: Businesses face increased production costs due to higher prices for raw materials, labor, and energy. If they choose to pass these costs on to consumers, it can lead to higher prices for their products and services.
8. Import-Dependent Industries: Industries heavily reliant on imported goods or materials may be significantly impacted by inflation, especially if the local currency depreciates. Imported inputs become more expensive, potentially leading to higher production costs and prices for consumers.

It’s important to note that the impact of inflation can vary based on individual circumstances, geographic location, and the overall economic situation. Governments and policymakers often implement measures to mitigate the adverse effects of inflation and ensure that vulnerable groups are supported during inflationary periods.

Advantage (Pros) and Disadvantage (Cons)
of Inflation for Individuals and the Economy

Inflation, like a double-edged sword, has both positive (pro) and negative (con) aspects. Let’s explore the advantages and disadvantages of inflation:

Advantages (Pros) of Inflation:

1. Stimulates Economic Growth: Mild inflation can boost consumer spending as people buy now, anticipating higher prices in the future. This increased spending elevates demand and stimulates economic growth.
2. Encourages Investment: Inflation often leads to an increase in asset prices, including real estate and stocks. Investors may be more inclined to invest, expecting better returns on their investments, thus encouraging economic development.
3. Reduces Real Debt Burden: Inflation decreases the real value of money over time, effectively reducing the burden of debt. Borrowers benefit by repaying loans with less money than when they borrowed.
4. Promotes Wage Growth: Inflation can boost wages as businesses attempt to retain employees amidst rising costs. This wage growth can enhance the standard of living for workers.

Disadvantages (Cons) of Inflation:

1. Erodes Purchasing Power: Inflation diminishes the purchasing power of money, meaning people can buy fewer goods and services with the same amount of currency. This reduces overall living standards.
2. Uncertainty and Economic Instability:High or unpredictable inflation can lead to economic uncertainty. Businesses find it challenging to plan for the future, and consumers become cautious about making long-term financial commitments, affecting economic stability.
3. Squeezes Fixed Incomes: Individuals with fixed incomes, such as retirees or those with fixed salaries, experience a decline in their purchasing power as prices rise, potentially leading to financial difficulties.
4. Higher Interest Rates: Central banks may raise interest rates to control high inflation. While this is a tool to reduce spending and control prices, it can also increase borrowing costs, negatively affecting businesses and investments.

Understanding these advantages and drawbacks enables policymakers to navigate inflation with the goal of finding a balance that promotes growth while safeguarding the economy and the well-being of the populace. Achieving this balance is a delicate task in managing a nation’s economic health and stability.

Who Is Responsible for Controlling Inflation?

Inflation is primarily controlled and managed by a country’s central bank and, as far as Malaysia is concerned, the central bank is BNM, and to the extent possible, the government. Here is how they implement control:

1. Financial Policies by the Central Bank:

The central bank, such as the Federal Reserve in the United States or BNM in Malaysia, bears the primary responsibility for controlling inflation. They employ fundamental financial tools, such as adjusting interest rates and managing money supply, to influence loan costs and regulate the flow of money in the economy.

• Interest Rates: The central bank uses interest rates (like the federal funds rate in the US and OPR in Malaysia) to control borrowing and spending. Raising interest rates can reduce borrowing and spending, aiding in controlling inflation.
• Open Market Operations: The central bank buys or sells government securities in the open market to control money supply and, consequently, influence interest rates.
• Reserve Requirements: The central bank can alter the percentage of deposits that banks are required to hold as reserves. By changing these requirements, they can control the amount of money banks can lend.

2. Fiscal Policies by the Government:

The government can also influence inflation through fiscal policies involving taxes and public spending.

• Taxes: Adjustments in taxes can affect consumer spending and investment. Higher taxes may reduce spending, while tax cuts can stimulate the economy.
• Government Spending: The government can stimulate or slow down the economy by altering levels of public spending. Increasing spending on infrastructure projects or development programs can encourage economic growth.

Managing inflation requires a balanced approach and often necessitates cooperation between the central bank and the government. The decisions made in controlling inflation have broad effects on the economy, so balance and coordination are key to achieving price stability.

3. Inflation Targets:

Many central banks have specific inflation targets they aim to achieve. For example, an annual inflation target of around 3%. These targets guide policy decisions to maintain price stability.

4. Supervision and Monitoring:

Central banks often oversee and monitor financial institutions to ensure they follow prudent lending practices. This helps maintain financial stability, which in turn affects inflation.

5. Market Expectations and Communication:

Central banks frequently communicate with the markets and the public about their policy intentions and inflation forecasts. This disclosure guides market expectations and influences economic behavior.

This is an indirect way for the central bank and the government to manage inflation. They aim to keep inflation within a target range that allows for healthy economic growth while avoiding the dangers of excessively high inflation. Achieving this balance is a delicate task in managing a nation’s economic health and stability.

Actions That Can Be Taken To Address Inflation?

Dealing with and Managing Inflation requires a comprehensive approach involving individuals, businesses, the government, and the central bank. Here is a guide on how to face, combat, cooperate, and adapt to inflation:

1. Understanding and Awareness: Knowledge is the first line of defense. Understand what inflation is, how it affects your finances, and what its causes are. Stay informed through reliable sources, economic literature, and news to make informed decisions.
2. Financial Planning: Develop a robust financial plan that takes potential inflation into account. Consider investments that historically offer returns exceeding inflation, such as stocks or real estate. Diversifying your portfolio can also reduce inflation-related risks.
3. Budgeting and Savings: Budget our spending to ensure we live within our means. Allocate savings to investments that have the potential to outpace inflation. Building an emergency fund can protect against unexpected price hikes.
4. Adjusting Spending Habits: During periods of higher inflation, reassess our spending habits. Prioritize essential purchases, cut unnecessary expenses, and look for more cost-effective alternatives without compromising quality.
5. Negotiation and Protection: Negotiate as best as possible for fixed costs like rent, insurance premiums, or long-term contracts to mitigate the impact of price hikes. Consider hedging strategies, such as inflation-indexed bonds or ASB, that can provide protection against inflation.
6. Skill Development and Enhancement: Improve skills and education to stay competitive in the job market. Skill enhancements can lead to better income opportunities, helping us cope with rising costs.
7. Educating and Advocating for Fair Policies: Engage in discussions about economic policies that can influence inflation. Support policies that promote price stability, financial responsibility, and responsible monetary practices.
8. Collaboration with the Government and Central Bank/BNM: Encourage collaboration between the public and government bodies. The public can voice their concerns, provide insights, and engage in discussions to ensure effective policies in addressing inflation while supporting economic growth and employment.
9. Supporting Small Businesses: Support local businesses to stimulate the local economy. Small businesses often bear the brunt of inflation; supporting them helps maintain a healthy economic ecosystem.
10. Long-Term Thinking: Develop a long-term perspective in financial planning and decision-making. Consider the potential impact of inflation on retirement, children’s education, and other significant expenses in life.
11. Financial Literacy and Education: Advocate for financial literacy programs in schools and communities to empower individuals with the knowledge and skills needed to navigate financial challenges, including inflation.

Addressing inflation is a collective effort involving informed decision-making, adaptability, financial wisdom, and collaboration between individuals and various stakeholders. Through proactive and informed actions, we can mitigate the effects of inflation and strive towards a stable economic future.

Conclusion:

Inflation can be a positive force when it is low and controlled, but it becomes a threat if left uncontrolled and excessive, as observed in neighboring countries. The actions we can take involve enhancing skills and income in line with increasing inflation to improve our lifestyle and future lives.