Sunday, March 16, 2008

Inflation and Its Role in Savings

The Inflation Facts

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
John Maynard Keynes

Throughout time, inflation has been a main economic problem for majority of countries all over the world. All the governments globally, without exception, view inflation rate as one important variable in their economic policies. In fact, the stability of economy in one country is generally measured by its inflation rate. Because of the important role inflation holds in economic issues, it has been something common if inflation dominates all the news related in economic and finance matters.

Inflation is defined as a sustained increase in the overall level of prices over a period of time. To be simple, this economic phenomenon causes price of the goods and services to rise. Inflation represents in this illustration; you buy one cup of coffee for Rp. 5,000 in one country which has an inflation rate of 5% per year, then the next year you buy the same coffee, it will be priced for Rp. 5,250. As a result, rising price caused by inflation decreases people’s purchasing power.

Every single person in this world, aware or not, has been dealing with inflation all the time during their life. Perhaps you still remember when as an elementary student, you used to buy a bottle of coke for Rp. 500, while now you have to pay Rp. 2,000 for the same coke. Or when you buy a dish of fried rice in the canteen for Rp. 5000, while as long as you can remember, last year it was just Rp. 4000. Inflation is an inescapable phenomenon, and as you experience it everyday, it will be congenial if you understand about it.

Inflation and the growth of money supply are strongly related. Most economists concur that the reason inflation happens is mainly because the government prints too much money. Due to the rising of money’s quantity in the market, the value of the money drops and causes price of the goods rises. This situation happened in Indonesia in the late 1950’s when President Soekarno issued a policy to print money as many as possible as the government ran out of cash. Indonesia later trapped into deep trouble as the policy caused inflation rate rising uncontrollably, which forced the government to reform the currency.
The government spending and policy may have an effect on inflation rate. In all circumstances, economic policy and spending of the government always focus on how to stabilize monetary and financial condition of the country. Therefore, the government allocates funds on sectors which are thought to be necessary in term of reaching the goal. The policies include subsidize, tax, banking policy, course of action in international trade, etc. If, for instance, the government has to allocate funds on other unexpected sectors, then the funds which are considered to stabilize the economic sectors will be decreased as a trade off. Natural disaster and warfare are simple examples of those unexpected sectors. Warfare destroyed economic activities and caused countries as Iraq, Lebanon, Afghanistan, have to allocate funds in rehabilitation of the country instead of monetary and financial sectors. The impact is immense, economic sectors of those countries devastated and leads to an astronomical inflation rate.
Inflation can happen because external factors from abroad, such as rising price of oil. The decreasing of oil supply causes the price to rise. Many producers find this objectionable, because they use oil as input to produce goods. Suddenly the rising price of oil will be followed by the rising cost of production, and the rising cost of production induces producers to increase the price of goods they produce. As the outcome, inflation happens as rising price causes decreasing in people purchase power.
Stability of currency may also cause inflation to occur. Without a doubt, higher currency rate means more purchasing power in the market. Consider Indonesian Rupiah currency is continuing to become weak against US Dollar. This is a huge loss for Indonesia in international trade knowing the fact that US Dollar currency still dominates market. The consequence is Indonesia will have to pay more against goods traded in the international trade. In the end, price for import goods sold in the country will rise and leads inflation to happen.

Different countries have different inflation rates. In Japan, there is no inflation -fantastically, the Japanese government manages to press down the inflation rate for less than 1% per year-. In Iraq, the United States’ invasion hit not only the sovereignty of the government, but the economic stability as well. In 2007, inflation rate in Iraq has gone beyond 40%. We can find an even worse situation in one no coast-line country in southern Africa. It is Zimbabwe, and the awfully economic mismanagement by President Robert Mugabe lead the country to 3000% of inflation rate -and is still raising-. The consequence of this hyperinflation is the money’s value in Zimbabwe plummets, yet the average monthly wage of people there can only buy two liters of cooking oil.

How Inflation Plays Important Role in Savings

Normal people always think that bank is the best place to keep their money. Bank gives them interest rate, so people will save their money in bank’s vault while hoping the money will be accumulated by the interest rate. Frankly, you gain nothing by saving your money in the bank. Bank is the right place to save, not to invest.

When you save your money in the bank, you should take inflation rate into consideration. Numerous people do not estimate inflation rate as they save their money in the bank. Inflation rate causes the money value to drop and price of the goods to rise. If you held money for a long time, its value surely will go down as an effect from the inflation. People who are not keen to take such risk normally just deposit their money in the bank for purpose of ‘long term investment’. They call it ‘investment’ because of the interest rate they get from the bank. The question is; does the money really accumulate?

We take one example to analyze it. Let’s say you are Indonesian who is going to save your money in one bank. Currently, you have a billion Rupiah worth of money and willing to open your savings account. The bank offers you 2 options, a normal account (interest rate of 3.5% per year) and a fixed deposit account (interest rate of 6% per year). You consider that a fixed deposit account will be one hell of investment for one year, because the next year you draw the money, you will gain profit of Rp. 60 million.
The bank’s interest rate on fixed deposit account is 6 % per year. Meanwhile, that time Indonesia has a yearly inflation rate of 6 – 6.5 %. Interest rate makes you receive more amount of money than before. But bear in mind that future money may have a different value than current money. In the future, it is true that you will get more amounts of money. But here we issue the value, not the amount of the money, as it is also true that you will get a different value of your money the next time you draw it.
So you have decided to put your billion rupiah into a fixed deposit account. Then the next year you draw the money, the 6% interest rate generates your money for Rp. 60 million. As a result after you clear your fixed deposit account the bank returns you a sum of Rp. 1,060 billion. Consider this as example; the previous year, your billion is able to buy 10 cars worth Rp. 100 million each. But, the time you clear your deposit the 6.5% inflation rate has increased the car value, which is now priced Rp. 106,5 million each. So at that time, those 10 cars are worth a sum of Rp. 1.065 billion. You will see even though you obtain more amount of money, you also obtain less value of money, which is caused by the inflation rate that actually decreases your purchasing power than before.

These two variables, inflation and savings, are both connected and importantly linked in economics studies. In actual fact, the government controls inflation rate by controlling interest rate in savings. If the government set the interest rate high, it encourages people to save their money in the bank, lessens money quantity in the market, and presses down the inflation rate. Conversely, lower interest rate will stimulate people against saving their money in the bank. It encourages people to spend their money in goods and services and investing in business. This will lead to an increase of money quantity in the market, and in conclusion, a higher inflation rate.

No comments: