What is inflation, what are its effects and what protection methods are available to business owners and managers?

At the end of a year, inflation is an indicator of the stability of consumer prices and the coordination of fiscal, monetary or legislative policies with those of the Central Bank. As it is an impossible to ignore aspect of a country's economy, it is important to know what inflation is, what its effects are and how you can protect yourself as a business owner from it.

Contents

1. About inflation and what causes it

1.1. What is inflation - information for everyone

1.2. Types of inflation

1.3. Why does inflation rise - the causes

1.4. What do high inflation and negative inflation mean?

2. What does inflation mean for business?

2.1. The effects of inflation on the business environment

2.2. Ways to protect your firm during inflation

1. About inflation and what causes it

Inflation is a highly controversial and complex phenomenon and is either a threat to sustainable economic growth or a possible stimulus to it. Although it has changed over time, inflation remains a hot topic in economics. The term first appeared in economic language at the end of the 19th century, associated with imbalances in the circulation of money.

In this chapter you will find out what inflation is, what the inflation rate is, how it is measured, as well as essential information about its causes and known forms.

1.1. What is inflation - information for everyone

Inflation is a general increase in prices and services in the economy, which leads to a decrease in purchasing power for both consumers and businesses. To better understand the phenomenon, one can take a commonly purchased product as a benchmark and compare its price in one period to another. But inflation is not limited to price increases for a single item or service, but refers to price increases across the whole sector (e.g. cars), and ultimately a country's economy.

How is inflation measured?

Inflation is measured by first determining the current value of a basket of certain goods and services consumed by households, called the price index. To calculate the inflation rate or percentage change, the value of the index from one period of time is compared with another. This period can be month-to-month, giving a monthly inflation rate, or year-to-year, giving an annual inflation rate. The inflation rate is therefore the percentage by which prices rise or fall over a given period of time.

Inflation aims to measure the overall impact of price changes for various goods and services because human needs extend beyond one or two products. These include commodities such as food, fuel, utilities, as well as services such as health care, entertainment and labour.

When prices rise, there is a decline in purchasing power. Basically, prices rise, which means that a monetary unit buys fewer goods and services. This loss of purchasing power has a negative impact on living standards, ultimately leading to a slowdown in economic growth. In order to combat this phenomenon, the monetary authority can take measures to keep inflation within acceptable limits and to ensure the smooth functioning of the economy.

1.2. Types of inflation

In general, too high inflation is not considered good for the economy, but neither is too low inflation beneficial. High inflation can harm savers by eroding the purchasing power of the money they have saved. However, it can be good for borrowers because the inflation-adjusted value of their outstanding debt is reduced over time.

Most economists believe that a moderate degree of inflation is healthy for a country's economy. As a rule, central banks aim to keep this index around 2% to 3%.

Depending on the pace of price increases, the main types of inflation are:

• Creeping inflation - represents a gradual and continuous increase in prices of up to 3% per year;
• Moderate inflation - refers to an increase in prices of 3-10% per year.
• Fast inflation - annual price growth rate approaching 10%.
• Runaway inflation - when the 10% annual threshold is exceeded.
• Hyperinflation - inflation rises rapidly by more than 50% and spirals out of control.

Depending on what causes it, inflation can also be:

• Demand-side inflation;
• Supply-side inflation;
• Cost inflation;
• Structural;
• Imported.

1.3. Why does inflation rise - the causes

An obvious question many people ask is why inflation is rising. Understanding the causes of this phenomenon is important to answer this question. Even though it is a normal part of global economic cycles, knowing how inflation starts and runs is essential to protect yourself from it.

So there are three main causes of inflation:

• Demand-driven inflation - this refers to when not enough goods or services are produced to keep up with demand, causing their prices to rise.
• Cost-driven inflation - occurs when the cost of producing goods and services rises, forcing businesses to raise their prices.
• Embedded inflation - occurs when employees demand higher wages to meet higher living costs. To compensate for wage increases, businesses will raise prices, leading to a wage-price rise loop.

Inflation can also be driven by high prices that are not directly related to rising demand or falling supply, by covering budget and external balance of payments deficits, or by excessive credit growth.

Inflation is also likely to result from other factors unrelated to the economy. Examples may include natural disasters or major global events that disrupt the supply chain and reduce the quantity of goods available, driving up the prices of remaining stocks.

1.4. What do high inflation and negative inflation mean?

As a country's economy grows, consumers and businesses spend more money on goods and services. When demand usually outstrips the supply of goods and producers raise prices, the rate of inflation also rises. Moderate inflation is associated with economic growth, while high inflation can signal problems in a country's economy. When there is rapid growth in demand and continuous price increases, while at the same time there are supply constraints, runaway inflation or hyperinflation can result.

At the other end of the spectrum is deflation, which occurs when prices fall for various reasons. A lower money supply can increase the value of money, which leads to lower prices. Likewise, a reduction in demand for various reasons, such as too much supply or reduced consumer spending, can lead to deflation or negative inflation. While it may seem like a good thing because it reduces the prices of goods and services, making them more affordable, deflation can negatively affect the economy in the long run. If businesses earn less money on the products they sell, they will be forced to cut costs, which means laying off employees and, in turn, increasing unemployment.

2. What does inflation mean for business?

Inflation occurs when there is a general increase in the prices of goods and services, not just individual items. Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programmes, tax policies and interest rates. Therefore, understanding the inflation phenomenon is crucial regardless of the area.

2.1. The effects of inflation on the business environment

Inflation is not always good for a company, and a very high rate has many implications for business performance. So it affects consumers directly, but businesses also feel the impact. It reduces consumers' purchasing power, as it takes more money than in the past to buy a product. So if people's incomes fail to keep up with rising prices, consumer spending will fall, which will also lead to lower demand and lower business revenues.

An extreme case of inflation is hyperinflation. Hyperinflation occurs when prices rise rapidly and erratically, usually at a rate of more than 50% per month. It occurs most often during financial crises or times of war, when the central bank prints an excessive amount of money. As a result, the supply of money exceeds the demand, the value of money falls and there is a sharp rise in the prices of goods and services. As basic necessities become much more expensive, the population will not be able to meet their standard living needs. The consequences will be poverty, unemployment and other social problems.

Without capital reserves in times of falling demand, businesses will be unable to pay their day-to-day expenses, eventually going bankrupt. In addition, lower corporate revenues mean that governments will also have lower revenues, leading to a reduction in social welfare.

Here are the potential risks of inflation for business:

• Lower demand for company goods and services;
• Lower sales and production;
• Risk of speculative investment;
• Higher bond payments;
• Lower demand for exported products.

Low inflation is a favourable situation that can have the following effects:

• A higher value of exports because prices are low and competitive;
• More investment by firms, which will take advantage of low inflation to borrow more money;
• Real incomes and more purchasing power for employees;
• Economic growth as spending and output rise.

2.2. Ways to protect your firm during inflation

In order to grow their businesses, owners and managers face many challenges, including inflation. With inflation on the rise and uncertainty in the economic environment, good planning is more important than ever. Whatever stage your business is at, the Mazars team in Romania is at your disposal with accounting, financial or business consulting services to support you through difficult times, helping you prepare and implement effective strategies to protect your business from inflation.

As a rule, those most affected by the effects of inflation are economic agents with low and fixed incomes because they are not able to compensate for the losses caused by price increases over time. Inflation does not only act negatively, there are many companies that can benefit, including borrowers.

Here are some of the most popular strategies for protecting your business from the effects of inflation:

• Protect cash reserves - when inflation rises it's important to remember that the value of money is falling. In other words, you will need more cash to be able to do the same things. So one obvious measure is to protect your cash reserves.
• Keep a close eye on your spending - at times like this it's important to make sure the spending you do makes sense. Any initiative needs to be carefully thought through at this time.
• Be flexible - when the price of raw materials or equipment rises, you may need to change your business strategy, which is perfectly normal in times of inflation. So the key is to avoid a rigid approach and be flexible enough so that you can adapt to change and maintain your objectives at the same time.
• Optimise your supply chain - one way to protect your business during inflation is to optimise your supply chain. This means working with trusted suppliers and carefully reviewing purchasing policies and protocols.
• Turn to technology to reduce costs - by implementing digital solutions, you can protect your business in times of inflation. Advanced technology equipment can help you reduce maintenance costs, improve efficiency and increase employee productivity.

So inflation is an overall imbalance in the economy characterised by two major trends, namely a general rise in prices and a decline in the purchasing power of money. It is a natural phenomenon in any economy and can have both a negative and a positive impact on businesses and consumers.

*This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.