Inflation is an increase in the price of goods and services.
Inflation can be caused by too much money being in circulation or when the demand for goods & services outpaces the supply.
For example after the covid 19 pandemic, inflation in Europe increased not necessarily because there was too much money in circulation, but because the factories were still reopening & could not produce enough goods to satisfy demand.
When inflation is caused by the inability of factories to produce enough goods, it is called demand pull inflation. Various factors such as a pandemic, conflict, industrial actions, etc. could cause the factories to underproduce.
However, excessive money in circulation which could be due to an increase in salaries, payment of palliatives, stimulus checks etc. can also lead to another type of inflation called cost push inflation.
In this case the factories are performing at their full capacity but people keep overpaying for goods causing the prices to increase.
What is the Ideal Inflation rate
The ideal inflation figure for a healthy economy is 2%. Inflation is not a bad thing but when its above 2% then it can begin to hurt the country’s currency.
The opposite of inflation is deflation & it occurs when the prices of goods & services are falling too quickly. During deflation people stop buying goods& services because they expect the price will fall soon & this also hurts an economy.
When the inflation figure is below 2% the economy risks falling into deflation.
How Does Inflation Affect A Currency?
Negatively
When a country’s inflation is high, its currency looses value & weakens.
Why? because as monthly repayments on credit cards & mortgages go up, people are less willing to spend money (only spending on essential needs & shunning wants).
This translates to lower sales & profits for manufacturers who may start laying off workers and the GDP of the country drops.
When the GDP drops for two consecutive quarters, the economy enters a recession.
The thought of this happening scares investors away so the demand for the currency drops thus weakening it.
Even famed investors like Elon Musk seem to agree. Look at this tweet from Elon Musk:
Positively
When inflation is high, central banks try to lower it by raising interest rates and this attracts foreign investors who want to earn higher interest on their investments.
However this only applies to healthy economies like the USA, UK, Australia etc.
If an unhealthy economy like Zimbabwe tries to increase interest rates, their currency will still not appreciate because the economy still has several underlying factors that will scare investors away.
An increased demand for a currency due to the higher interest rates, causes it to appreciate in value
Look at this tweet from Robert Kiyosaki, renowned investor & author of best selling book “Rich Dad, poor Dad”
If the US Federal Reserve increases interest rates, the US Dollar becomes stronger & Gold becomes weaker.
Why? Because Gold is a so called “dumb stone” that doesn’t earn you interest and investors only flock to Gold for safety (when the dollar is falling)
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