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Explain Like I am 5 - Inflation

20 years ago, it took an adult to lift 200 INR worth of groceries but now even a 5 yo could do it. Conclusion - We are getting stronger!

Inflation. But who cares?


The price you pay for goods and services is not constant but keeps changing with time. Let's say you can use x amount of money to buy a specific number of hours of gameplay of your favorite game at a local video game studio. In general, five years down the line, you wouldn't be able to buy the same hours of gameplay in the same studio for the same x amount of your money. This is because the value of the money you use keeps on degrading and after 5 years, the value of x amount of money would not be the same as now So you would need some more money for the same.

In simple terms, this rise in the cost of goods and services with time is what inflation is. It happens because the value of money keeps on decreasing compared to the value of goods and services you want to exchange it for.

We generally think prices always increase, but that may not be the case. There are periods when prices actually go down instead of increasing. This is called deflation.

Consider this case - let us say you have 20k INR at a given time. You can buy a specific amount of goods/services in exchange for your money at that time. But you decide to keep the money with you for one year. What will happen after a year? Given inflation, the amount of goods/services you could buy with your 20k INR will likely decrease a bit with time. And you will see this decrease every year you decide to keep your money safe with you.

This is the direct effect of inflation - The purchasing power of a unit of currency decreases with inflation. The higher is the inflation, the more is this decrease.

Q. Does this mean your hard-earned money is losing its value?

A. In short - Yes.

Q. Is inflation evil?

A. It may look like, but not necessarily. There has been a lot of debate on this subject and people tend to have different views, but the majority of economists agree that a little inflation is actually good for society and the financial systems we have built in the world.

Q. I am losing the value of my money, this is bad. Why do we even have Inflation then? Why not should we find a way to get rid of inflation?

A. Yes, you want your money to not lose its value! and no, we should not get rid of inflation. We surely want a little bit of it. It is kind of a necessary evil.

You know from above that inflation actually penalizes you for storing cash instead of exchanging it with goods and services available. A moderate amount of inflation always incents spending money in exchange for some goods or services. It makes people spend (which is opposite to making people not spend and hold on to their cash) in the economy. It makes cash flow from one place to another. And that is always a good thing for any economy.


One more way to think about Inflation -

Let's say you are running your shoe manufacturing business. Given the complex processes involved, it takes your company a year after gathering all of the raw materials to prepare the final finished product, i.e. shoes.

Suppose you bought your raw materials at value x and the current (at the time of buying raw materials) market price of your finished product is y (the price at which you have to sell your shoes). The total profit you would be making on this is y- x amount.

After one year, when you are actually going to sell the shoes your company has produced, the market price increased to y + y’ due to inflation. So now your total profit would also rise by y’ amount. Congratulations! More profit. So you (the investors) are encouraged to produce more and more goods as you are earning more profit per unit of product. And this is how the economy grows.

Q. Okay, so if investors make more profit from inflation, what if our game plan is to increase the inflation even higher and make an agreement with the investor to pass on that excessive profit they earn to the company workers - who also happen to be customers in some twisted way? Isn't this going to be a win-win situation for everyone?

A. Unfortunately, no. If the inflation is too high, the cost of the final products and services will become too high, and eventually, people will stop buying it - because they simply can’t afford to have it. This will lead to a decrease in sales, the profits of investors will decline, which will further be passed on to the workers and then to the economy in general. In short, this will restrict the flow of money - which is a classic sign of a bad economy.

So in a nutshell, some moderate amount of inflation is good as it boosts the economy by benefiting the scaling up of goods and services and inhibiting cash flow in the economy. But if it is too high, the flow of money stops making the entire economy suffer.

PS - We are not getting stronger.


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