We might have come across this phrase “Rising prices is the cause of inflation“.
Is this really true? In the world of finance, cause and effect is often misunderstood.
I’m no economist – but I will try to explain in layman terms what inflation is.
First of all, the phrase I quoted at the start of this post is of course completely false.
Rising prices is the result of inflation, and not the cause of inflation. So what exactly causes rising inflation?
The money supply or the quantity of money in circulation.
There are a few ways that a government can fund its expenses:
- Taxation
- Borrowing from people
- Borrowing from banks
- Printing more money
There is no increase in the supply of money for the first two ways, but there is for the other two. Credit extended by the banks also increase the amount of money in circulation.
If a certain amount of money is printed but the population saves up the same amount of money, the quantity of money in circulation does not really increase.
However when people realise that their purchasing power is reducing, they are more likely to spend today than to put off their purchases for the future. With the addition of the printed money, this means the money supply has been increased.
An unavoidable consequence of increasing the money supply is that prices for everything will rise. Of course, asset values and wages will also rise proportionally.
Most (if not all) governments adopt a pro-inflation policy as it is easier to fund their expenses by increasing the supply of money than to raise taxes. For Singapore, the money in circulation increased from $8.1 billion in 1991 to $17.6 billion in 2006 (click here to view the numbers from MAS).
Furthermore, inflation has a feel-good effect on the population.
Don’t you feel wealthy when the HDB you bought 30 years ago at only $20k is now worth $600k? Or that your salary has increased from $100/month to $3000/month now?
The truth of the matter is that nothing has really changed for you. A bowl of noodles that used to cost $0.10 might cost $3 now. Your salary can still buy you 1000 bowls of noodles, both today and 30 years ago.
On the other hand, if you had left your $10k under your pillow, it will be worth considerably less today.
Ultimately, money is just a form of storage for value and the effects of inflation can eat away at the value of your money.
Inflation as a whole is bad for all creditors. As prices rise, the purchasing power of the principal and interest payments will be worth less. Less goods can be bought than at the start of the loan. Unfortunately, creditors does not refer to only the banks. Everyone who has a claim to any deferred payments is a creditor.
Your savings, your CPF funds, your insurance policies, your pension – all these make you a creditor.
The debtor on the other hand can profit from inflation. The purchasing power of his loan gets smaller with time. If inflation is higher than his loan interest rates, he benefits from inflation.
An interesting thing to note about the rises in prices is that not all prices and wages increase at the same time. Companies who can increase the prices of the things they sell while the prices of the goods they buy has not risen can profit from inflation. These business thrive in an inflationary environment.
On the other hand, there are business who cannot raise their prices fast enough to offset the increasing prices of the things they buy.
The middle class as a whole generally lose out as their salaries go up slowly compared to the rise in their cost of living. The pack of rice that used to cost me $5.80 a few months ago has now doubled in price.
In Singapore, the lower income contract worker have it even worse. The newspapers reported yesterday that their wages have in fact decreased compared to what they were being paid ten years ago.
Times are very challenging for all of us – each in his or her own way.
Personally, I find it frustrating that the returns on my investments has to first overcome the high inflation rate before it even goes into any real capital growth. Failing which my wealth will get smaller and smaller.
