When the prices or goods (products) and services rise on average in an economy, it's called inflation. It is also known as CPI or Consumer Price Index.
In South-Africa it is measured on a monthly and annual basis by the Department of Statistics. The measure the price of a "basket" of goods" on a regular basis.
This "basket" is representative of the average lifestyle and consumption of South-Africans. Each one of us has a slightly different rate of inflation, based on our specific lifestyles.
Inflation can also be described as the diminishing value of the buying power of money, in other words, one can buy less with R100 than 1, 5 or 10 years ago etc.
There are really just two underlying causes of inflation:
1. The monetary authority (SA Reserve bank) prints too much money.
Like anything else, when its supply becomes relatively abundant, money loses value.
2. The expectations mechanism. If everyone expects money to lose value, everyone will try to get rid of it quickly, and the easiest way to do this is to spend it. But this is just a game of hot potato. Dick buys something from Jane and gives her money. But Jane doesn't want to hold money either, so Jane buys something from Tom. Now Tom tries to get rid of the money by buying from Harry, and so on. This creates demand for goods and services and before long, all these purchases start to make prices rise, justifying everyone's initial fear.
The SA reserve bank inflation target is between 3% and 6% per annum. There is really only one effective measure for the Reserve bank to lower a rising inflation rate, namely the interest rate. If inflation rises above the target set by the Reserve Bank, they will typically up the interest rate that they charge banks. Banks, in turn, will increase the interest rate they charge
their clients will should lead to lower borrowing by clients, less spending, lower demand for goods and services and lower inflation.
If the inflation decreases within certain parameters the Reserve Bank will typically lower the interest rate that they charge banks. Banks, in turn, will lower the interest rate they charge
their clients which should lead to higher borrowing by clients, more spending, higher demand for goods and services and increasing inflation. This is a continuous cycle.
Why is high and very low inflation bad for our economy?
High Inflation: For consumers, higher prices on essential goods like food and petrol may become unaffordable for people whose income is not rising as much.
But even when their income is rising, higher inflation makes it harder for consumers to tell if a
particular product or service is getting more expensive relative to other goods, or just in line with the average price increase.
This can make it harder for people to budget appropriately. this goes for businesses as well. When the Reserve Bank incraases interest rates, there is less demand for products and services and this slows down SA's economic growth.
Low inflation: Very low inflation usually signals demand for goods and services is lower than it should be, and this tends to slow economic growth and depress salaries.
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Author: Anton Schutte: General Manager and Certified Financial Planner CFP®: PWG Group.