The definition of inflation can be a little tricky because the definition has been adjusted and skewed over the years. For example, below is Investopedia’s definition of inflation:
Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency. As prices rise, they start to impact the general cost of living for the common public and the appropriate monetary authority of the country, like the central bank, then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly. Inflation is measured in a variety of ways depending upon the types of goods and services considered and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0 percent.Investopedia
This definition cannot be further from the truth. Inflation has nothing to do in terms of rising prices; rising prices are a result of inflation. Let’s try another definition, this time we’ll go with Google.
A general increase in prices and fall in the purchasing value of money.Google
Eh, another example of the definition of inflation being skewed to mislead individuals. It’s no wonder why they continue to update dictionaries.
The Real Definition
The best definition of inflation is from the 1991 Webster’s Dictionary.
An increase in the amount of money and credit in relation to the supply of goods and services.Webster’s Dictionary 1991
This definition is much better; it speaks about something the previous two don’t mention at all which is an increase in the money supply.
The truth is inflation is merely a matter of increasing the currency supply. It’s is not about rising prices; rising prices are the result of the inflation.
Note: I don’t like to intertwine currency and money as the same because money and currencies are two different things. However; I’ll discuss the differences in a later post. But for now, know that currency and money are not the same.
What Are The Causes?
Only governments or central banks can cause the expansion of the currency supply, not economic activity. Therefore, if the supply of currency has increased while the amount of goods or services has not, the price of those goods and services will increase.
Since the central banks or the government control the supply of currency, then that means inflation can only be supply by the government or central banks.
Why Is Inflation So Important To Understand?
You have to understand inflation to invest your money correctly. You must have an idea of what the rate of the currency expansion is; otherwise, you could end up losing money even if your investment has a positive return.
For example, let’s say an investor invested his/her currency into a company’s stock and managed a 3% return on their investment.
Naturally, they would be led to believe they made 3% more currency; however; if the rate of inflation is 5%, then the investor lost 2% from their investment due to the loss of purchasing power.
It’s important to know what the inflation is so you can determine if it’s worth investing your currency into a particular investment. If you believe the investment will not provide you with a rate of return that’s higher than the inflation rate, then it’s not worth the risk.