Inflation is sometimes called “the pulse of the economy”. Do you remember how much you paid for bread or milk when you were a child? Most probably less than now, right? If you keep your money in a sock, a year from now, your cash will buy you less goods today. This increase in the general level of prices is called inflation.
Inflation is measured as an annual percentage increase of prices for a defined set of goods and services.
What creates inflation
Inflation normally occurs if there is more money in the market than goods. These situations are quite normal in growing economies where people start earning and spending more but the production or import cannot keep up.
Another cause of inflation can be the increasing costs for businesses. For example, when the prices of oil and gas go up, it affects the end price of nearly every product and drives the inflation up.
People generally fear rising prices, but inflation is not always bad. Its effects depend on your financial situation, state of the economy and whether inflation is expected or comes suddenly as a surprise.
When inflation is a good thing
Shorting a currency
If you are a forex trader who has gone short on EUR/USD (hoping that the euro will lose its value) and Eurozone is hit by big inflation, you will have a winning position (if the US will not experience the same), as the value of dollar will rise against the euro.
Inflation is a sign that the economy is growing, so rising inflation is what countries are looking for after an economic crisis. Inflation means that people have money and they are willing to spend it.
If you have borrowed money before the inflation and the lender has not anticipated the inflation, then you basically can return less money.
MasterCard used this principle creatively to protect their profits in Venezuela. In 2015, the inflation of the Venezuelan bolivar was estimated to reach almost 200%. Therefore, MasterCard came up with an unusual hedge idea. It took out a loan in bolivars and used that cash to buy property, whose value is typically set in USD in Venezuela. So when the bolivar is devaluated, the property also devalued, thus they have to pay back less for the loan.
When inflation is a bad thing
If you are a forex trader who has gone long on EURO/USD (hoping that euro will rise in value) and the Eurozone is hit by big inflation, you will end up in a losing position.
Uncertainty about whether inflation will increase further or not forces consumers and businesses to spend less, thus hurting the local economy.
If you have lent your money before the inflation, you will lose as the money will have less buying power after the inflation.
Deflation is the opposite of inflation. It means that the general level of prices is decreasing. Falling prices sound awesome, but Not if they las fo a long time. A single month of deflation is not bad.
But if deflation is prolonged, it comes with strange deflationary psychology: consumers and companies stop spending money as they hope that the items they want to buy will soon become even cheaper.
This created a chain reaction that often leads to stagnation or regression. A painful example was Greece in 2014/15:
1-As the crisis and austerity measures continued, the demand weakened.
2-Businesses were forced to cut prices.
3-Consumers stopped spending as they anticipated prices to fall even more.
4-Businesses had no income and had to lay off workers.
5-With increasing unemployment, the situation worsened.
6-As the spending didn’t resume, many businesses went bankrupt.
7-The Greek government debt continued to grow as tax revenues shrink.