Food, healthcare, shelter, clothing & education have become costlier in the last few months. Do you know why? Inflation. The increasing cost of living has everyone worried, be it Canada, the US, or India. One key aspect that troubles each individual on a global level is Personal Finances.

There is a very detailed relationship between household budgets and inflation. How we spend day-to-day and do financial planning is directly related to the prices.

So it is the need of the hour to know about some basic concepts like increase in prices and how to deal with it while making a budget. Let’s get going.

Meaning of Inflation

First, let us commence by understanding the meaning of inflation in layman’s terms. It means an increase/rise in the prices of products or services over some time. Because of this, the cost of living is affected. Which ultimately leads to a decline in the purchasing power of a person. 

This phenomenon happens on a global scale. No country can escape inflation. All they can do is deal with it. There is a metric to measure it known as “CPI” or the Consumer Price Index. With this measure, we can understand the change in prices over some time. 

Here is a list of CPI of the top 5 countries in the world. (Data latest till May 2024)

1. USA– 313.23
2. China– 100.3
3. Germany– 119.1
4. France– 119.71
5. United Kingdom– 133.9

You might be wondering how to read and analyze these figures. Okay, so for example Germany has a CPI of 119.1. It means there is a 19.1% increase in prices from the base year. The base is taken as 100. Likewise, for China it is 0.3%, for France, it is 19.71%, and so on.

Reasons of Inflation

Now that we know the meaning of inflation. Let’s figure out its reasons. Given are three basic reasons that lead to this situation:

1. Supply and Demand

The imbalance between supply and demand leads to inflation. Imbalance means- that consumers want more goods and services, but the supply is less or restricted. 

2. Disruption in Supply Stocks

Following the war between Russia and Ukraine, the energy prices surged. Because of the war, Russia restricted the energy supplies which tightened the market. Furthermore, due to such disruption, the prices of energy supplies increased leading to a disbalance.

3. Future Expectations

It is the mindset of people that in the future prices will increase and to prepare for it they start asking for a hike in their salaries and wages. To cope, producers will raise the prices of goods.

Effects of Inflation on Household Budgets

Given below are the effects of inflation on Household budgets and their implications.

1. Erosion of Purchasing Power

The first and foremost effect of inflation is on the purchasing power. If your salary is $100 then you can afford a certain level of products. Due to inflation, this level will decline and your cost of living i.e. your purchasing power will decline. It doesn’t matter if CPI is 2% or 4%.

2. Impact on Low-Income Consumers

People with low incomes already have less money to spend. Out of which they spend a huge chunk of just the necessities. The leftover is either invested or saved. Because of upturn, the extra money left will also become less and less as necessities increase in price. The ultimate effect is that they cannot save for the future.

3. Painful Recessions

Who can forget the 2007-08 recession period? Due to inflation, the rate of unemployment will prevail which in turn creates more havoc. To keep their jobs people will readily accept whatever is paid to them. Some might ask for an increase and get. But this whole situation leads to an Inflationary Spiral. In the 1970s, stagflation in the US led to an inflationary spiral.

4. Hike in Interest Rates

To deal with, the government will try to frame monetary policies to regulate interest rates. There is a direct relationship between inflation and interest rates. So, if the former is high the interest rate will be high. Taking loans from FI means paying high borrowing costs. Developed countries usually have a 2% rate and developing countries have between 3%-4%.

Balancing a household budget is difficult when prices are continuously increasing. The financial stress it puts on people is sharp. From the future aspect also it can change how you save. Your retirement savings might not be much because real worth can change.

Inflation affecting Household Budgets: Final Thoughts

What we can analyze is that inflation is both a curse and a boon. It depends on how you perceive it. To support the residents the government will often fix inflationary targets. Consumers will keep on buying at nominal rates. When the spiral hits, and the situation changes.

Inflation has a huge impact on household budgets globally. It reduces the purchasing power and leads to recession. It is therefore crucial for people to adopt the right strategies to mitigate its effects.

What do you think are the effects of inflation on the economy? Feel free to comment down below.