Inflation Causes Recession – How to Plan Ahead
Inflation is a percentage figure used to describe a general rise in the prices of goods and services that we purchase. It is measured on a ‘basket’ of a select group of goods and services based on the consumption patterns of the average household in an economy. For example, if a particular basket cost $100 in Year 1 and the same basket cost $103 in Year 2, inflation is measured as 3%.
Controlled inflation is good for an economy. Steadily rising prices mean that companies generate more income, which they can use to grow their business, hire more workers, and pay workers more. Left unchecked, however, inflation can lead to recession.
As prices rise, the profit margins of companies start to get eroded. When this happens, businesses try to cut costs to preserve profits. Often, this cost-cutting exercise is at the expense of workers who get laid off from their jobs. When workers are laid off, they are less inclined to spend on non-necessary goods and services, and as a result, the economy starts to slow down and may even slip into a recession. The general definition of a recession is often seen as two consecutive quarters of declining year-on-year GDP growth.
Causes of Inflation
There are several forces that can trigger inflationary pressures in an economy.
Demand-pull inflation: When there can be excess demand for a set of goods and services in an economy, there are always some customers who are willing to pay a higher price to acquire those goods and services. This surplus of demand over supply can cause inflation.
Cost-push inflation: When the prices of the raw materials of goods and services go up, those higher costs get passed on to customers in the form of higher prices for the final goods and services. As a result, this causes inflation.
Greater supply of money: In most countries, the central bank controls the money supply (i.e., the number of notes and coins circulating in an economy). When the money supply of a country is increased faster than the production growth that the country is achieving, that means that more dollars are chasing relatively the same number of goods. Consequently, inflation rises.
Currency devaluation: If there is a devaluation of a country’s currency, its exports become relatively less expensive to purchase. This encourages other countries to purchase more of its goods and services. Devaluation also makes foreign goods more expensive to purchase, so citizens end up buying more domestic goods compared to foreign imports.
Policy: Sometimes, governments may opt to implement subsidies or tax benefits for a certain type of good or service. When this happens, the price of goods or services offered to consumers is lowered. This increases demand for that particular good or service, and causes higher inflation.
What are the effects of a recession?
During a recession, there are adverse impacts felt by both businesses and families. As noted above, businesses may have to conduct layoffs during a period of recession to cope with rising costs. At a family level, that translates to people having to make choices about their lifestyle. Instead of going on an annual vacation, families may opt to skip it in favour of a less expensive domestic excursion. Instead of buying more expensive brands of perfume, bags or other luxury items, families may opt to stick to non-branded items. This reduces the amount of spending in an economy, which, in turn, slows down economic growth.
How do you prepare for a recession?
To ensure that you and your family are braced for the impacts of a recession, here are some tips to help strengthen your income and control your expenses even in a rising price environment.
Create a monthly budget: In recessionary periods, it is more important than ever to have a budget that you track diligently and adhere to. Ensure that this budget prioritizes your most important, necessary expenditures (such as your rent, mortgage payments, food, transport, etc.). In the short term, try to minimize discretionary expenditures such as eating outside at fancy restaurants, buying big-ticket luxury items, etc. Thereafter, if you have residual income, it may be wise to collect that in a high-growth savings account or invest it in opportunities when asset prices of stocks and properties are down.
Develop another income source: One of the most detrimental consequences a person can face during a recession is the loss of their job. This becomes particularly difficult if that job is a family’s single source of income. Having another job or a side hustle such as a freelancing gig or e-commerce venture can insulate you and your family from the sudden loss of an income source.
Build an emergency fund: An emergency fund is a lump sum of cash set aside in an account that is intended to be used only in emergencies, as the name suggests. Most personal finance experts recommend keeping at least three to six months’ worth of your family’s monthly expenses aside, which can help you weather near-term uncertainties during a recession.
Pay off high-interest credit accounts ASAP: It may be tempting to make purchases on your credit card during a recession to preserve the cash in your bank account. However, it doesn’t take long for the debt to pile up and start accruing interest at high rates (up to 20%+). As such, it is prudent to use credit wisely and continue paying off debts in descending order of their interest rate.
Upskill yourself: A recession can be a great time to learn new skills and bolster your resume through new certifications or experiences. This can help you become more valuable to your existing employer (therefore potentially saving you from job loss) and command a higher salary once the recessionary period is over.
A recession can be unpleasant and taxing – both financially and emotionally – on families and individuals. However, you can keep consequences at bay by following a disciplined financial plan and mitigating non-necessary expenditures.
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