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What Is Inflation?

Inflation is a term used to describe the change in price of a bundle of products and services over time.

Normally, it’s defined as a rate. For example, if the total price of a bundle of goods and services was $100 a year ago and now it’s $105, then the inflation in the last twelve months of those items is 5%.

How Is Inflation Determined?

Public institutions set a specific bundle of products and services, and find the weighted average of price change over a timeframe to determine the nation’s inflation.

These means that while some prices of the items in the bundle could have increased 20%, the overall inflation might yield lower, as many other items had a lower inflation increase. For example, the price of motor fuel increased 49.6% from October 2020 to October 2021, but the overall inflation in this same period was 6.2%—which is still a historical 30-year high.

Why Is Inflation a Concern?

Inflation concerns everybody, because it makes money saved less valuable due to the price of the products and services increasing while your money saved in the bank remains the same.

This means that your “purchasing power” decreases, and therefore the value of your money is less. Your $100 dollars in the bank now buys you less goods and services than previously.

What Causes Inflation to Increase? 

In an economy, there are different sets of circumstances that can drive inflation up or down. Some of these are:

• Low supply of raw materials: when this occurs, as is the case currently, the prices of raw materials tend to go up. These increases are generally passed on to the consumers, resulting in higher prices
• Wages increase: as in the previous point, production costs rise as wages increase, which then tend to be passed on to consumers
• Increased demand for a product/service: all else equal, a perpetuated increase or sudden spike in demand tend to pull prices up, as there are more willing buyers demanding the product or service, while the supply stays the same
• Low interest rates: encourage investment and consumption, increasing both the demand for capital goods and the demand for end products. All else equal, an increase in the aggregate demand will generate inflationary pressure explained by producers having to catch up to the higher demand from consumers (in other words, “many bucks chasing fewer goods”)

How Does Inflation Affect Businesses?

Some of the ways inflation can affect your business’ operation are:

• the increase in cost of raw materials can shrink your business’ profits
• if the expected inflation is high and uncertain, the purchasing power of the expected distribution of earnings (profits) from your business is lower
• employee costs can increase as people demand higher wages to maintain their purchasing power, resulting in a reduction of profits
• the demand for your products and services can reduce due to customers not being able to meet an increase in prices

How Can Inflation Impact Your Business´ Value? 

Your business’ value can be affected by inflation in different ways.

Based on the prior points, the earning power of your business could decrease, and therefore the cash flows that it can generate to an investor would be less, driving down the value of your business.

A high inflation rate does not instantly mean that your business’ value will be affected. If inflation is expected to go back to normal levels, then all else equal, the required rate of return from investors in your business can remain untouched.

However, if investors don’t trust that inflation will go back to normal levels, the uncertainty could result in investors requiring higher rates of return in order to cover themselves from possible reductions in purchasing power of their money and/or instability of the economic conditions in the country.

Conclusion 

Inflation concerns everybody. The repercussions from a high and/or uncertain inflation can be detrimental to the value of your money and your business.

It’s important that businesses are aware of potential impacts, and to plan ahead or hedge their risks to potential losses in revenue and shrinking of margins.

If you’d like to know more about how your business’ value can be impacted by inflation or other economic factors, contact us anytime.