Inflation helps solve mystery of the shrinking dollar

PUBLISHED : Monday, 22 October, 2007, 12:00am
UPDATED : Monday, 22 October, 2007, 12:00am

You are about to pay for your usual muffin. Today, you have the exact change. But the cashier tells you: 'One dollar is missing.'

You look at your coins, puzzled. Then you glance at the price list on the wall. 'You have increased the price!'

The cashier smiles and tells you that they had to do it after two years. But why? The cashier explains: 'Everything is more expensive; flour, labour, electricity, rent ...' Then she finally utters the magic word: 'inflation.'

Inflation means a decrease in the value of money. Why does this happen? Because the supply of money is higher than the demand. With more money around, the value of one dollar, for example, is lower because it is easier to find.

So if one dollar is worth less now than a few months ago, manufacturers will raise their prices to make up for this loss.

Inflation can have a snowball effect: if prices of raw materials are hit first, manufacturers will pass on the higher prices to their own products.

This in turn will affect the consumers.

All prices may not rise at the same pace. Some prices may even go down while others go up.

But why does the demand and supply for money change? The demand comes from what people need money for. In growing economies, it is a natural trend for the demand for money to grow as well.

The supply is usually determined by the central banks which print the money. Countries in debt or trying to boost their economies might be tempted to print more banknotes.

As international trade is a big part of a nation's wealth nowadays, inflation can spread from one country to another.

Rising prices affect daily life

Inflation has an impact on our behaviour, especially when we decide to spend or to save.

High inflation will make us buy products today, because they will be more expensive tomorrow. It also has a negative impact on saving: why save when the value of money goes down quickly?

Low inflation, like in Hong Kong, provides an incentive for investing. When we save, we only leave our money in a savings account at a bank. So the net return - the interest the bank gives minus the inflation - might be nil, or sometimes negative. Investing in the stock market or in property offers a way to beat inflation and get a higher return on your money.

Inflation often has a long-term impact on salaries. Employees will ask for higher pay to maintain their purchasing power - that is to be able to buy the same items even though the prices have gone up.