What does inflation mean for you and your money?
With prices steadily rising, you might be wondering what the current inflation means for your savings. Here you’ll learn about the effects of inflation on your personal finances.
8 min read
Whether it’s fuel for your car or your weekly grocery shopping, prices are currently rising in almost all areas of life. People are increasingly talking—and worrying—about inflation in Germany. But what exactly happens during a period of inflation, and how does it affect you?
The effects of inflation can vary depending on whether you have debt or savings—and in this article, you’ll learn why. Using historic examples, we explain what inflation means, how inflation differs from deflation, and what the European Central Bank is currently doing to keep inflation under control.
What does inflation mean and how does it affect you?
During a period of inflation, prices rise. This causes the currency—for example, the euro—to lose value. Imagine a scoop of ice cream used to cost €1.20. With inflation, the same scoop of ice cream might cost €1.40 or more. You won’t get a bigger waffle, extra chocolate sauce, or more ice cream. You simply pay a larger amount of money due to the devaluation of the euro. Many other things will be more expensive too—butter, for instance, or gas and fuel. Because prices are higher and therefore more money is circulating, the currency will continue to lose value. But why do prices rise in the first place?
What are the causes of inflation?
There are several factors that can cause inflation. First of all, it’s a natural economic phenomenon because markets are always subject to fluctuations. This has a lot to do with the laws of supply and demand. For instance, if energy prices are rising due to geopolitical tensions or other external factors, businesses face higher production costs. In order to balance higher costs and stay profitable, suppliers typically pass these costs on to customers by increasing their prices. If raw materials such as milk become more expensive, your favorite ice cream parlor is then forced to charge higher prices to their customers too. This phenomenon is called cost-push inflation.
Inflation can also be caused by higher demand. Imagine the number of people wanting ice cream rises so drastically that supplies become scarce. Businesses often react to a surge in demand by increasing their prices. This is called demand-pull inflation and often goes hand in hand with an increase in wages. However, higher wages can devalue the euro even more and cause a wage-price spiral. Why? Because a bigger salary means you can still afford expensive ice cream and won’t have to change your financial habits. As a result, demand stays high or even increases.
What does the inflation rate indicate
Inflation is measured as the rate of change of prices, and is usually displayed in percentage. However, the inflation rate does not necessarily show real inflation, because it is measured by the consumer price index—a representative sample of goods and services. In real life, however, consumer behavior naturally differs from person to person. That’s why individuals may perceive inflation very differently, depending on their personal consumption behavior. The EU inflation rate, for instance, was at 0.7% in 2020, but was generally perceived to be higher.
This doesn’t mean that you shouldn’t worry about inflation at all, especially if you’re on a budget and need to save money. However, inflation can have positive effects too. Read on to learn why!
Inflation and deflation: the differences and effects
Whether it’s demand-pull inflation or cost-push inflation, rising prices can lead to economic growth and an increase in purchasing power. You might be able to guess what happens to your debt during an inflation: Your real debt burden will fall, which means it will be easier to settle your monthly payments. That’s why inflation does have some positive effects. What is worrisome, though, is a phenomenon called hyperinflation: rapidly rising inflation at a rate of 50% or higher. This was the case, for instance, during the German Inflation of 1914-1923 in the Weimar Republic. In World War I, the German Mark lost its value, the government recklessly printed money, and inflation skyrocketed. At its peak in 1923, 1 Dollar was worth 1 million Mark, which shows just how worthless the German Mark was at that time. Luckily, the current situation doesn’t resemble that of 1923, despite rising prices.
The opposite of inflation is deflation, which causes an increase in the value of a currency. From an economist’s point of view, deflation is more problematic than inflation. Deflation is often a result of overproduction, which leads to a decrease in prices and an increase of a currency’s value. Money becomes a scarce commodity and purchasing power decreases, because it makes more sense to keep your money in your bank account rather than spending it. As a result, the economy cools down, wages drop, and unemployment rises. A downward-spiral may develop, since lower salaries will further decrease purchasing power and slow down economic growth. This was the case, for instance, during the economic crisis in the U.S. in the 1930s.
On the upside, deflation can benefit investors. A strong currency also increases the value of company stocks, so you’ll benefit from higher interest rates on your investments—as long as the central bank doesn’t lower the interest rate. In the next section you’ll learn what this means.
The European Central Bank’s monetary policy
Inflation and deflation are not only caused by demand and supply, but can also be influenced by financial instruments. The European Central Bank (ECB) can change the interest rate in order to steer pricing. For a number of years, the ECB followed a zero-interest-rate policy, meaning the ECB interest rate was 0.00% (as of March 24, 2022). As a result, banks weren’t able to offer profitable interest rates to their customers and savings accounts didn’t yield returns. Money can’t really grow without a positive interest rate.
The idea behind a low interest rate is simple: If it doesn’t pay off to keep money in our bank accounts, we’d rather spend it. This applies both to individuals and businesses. Spending money boosts the economy, which leads to a rise in demand, more investments, higher employment rates, bigger salaries, and an increase in prices.
How does the European Central bank combat inflation?
In Germany, inflation has been stable for the past ten years and stayed below the ECB’s target of 2.00%. However, the inflation rate has been rising since 2021 and is at 7.9% as of August 2022, mostly due to geopolitical tensions. In Austria, inflation was at 9.3% in August 2022.
To fight price inflation, experts call for a restrictive monetary policy with higher interest rates. The result should be that we spend less money and start growing our funds. Demand should decrease and prices should drop, which would benefit lower income groups. Although the ECB was initially slow to adopt a more restrictive policy, it has now increased the interest rate twice in 2022. As of September 2022, the ECB’s deposit rate is 0.75%, while the main refinancing rate is now 1.25%.
The US central bank, the Federal Reserve, had already changed their interest rate from 0.25% to 0.5% on March 17, 2022, while the ECB lagged behind until the summer—despite the relatively high inflation rate. So why the hesitation?
As already mentioned above, economists worry more about deflation than inflation. A rate hike might slow down economic growth, which causes salaries to go down and unemployment to rise. This further weakens the economy, and it doesn’t solve the problem of high energy consumption costs. Businesses would still have to pass higher costs on to their customers by increasing their prices, and the central bank might not actually hit their strategic target. Consumers could lose their purchasing power, while consumer prices could continue to rise. Higher interest rates might be beneficial for your savings, but loans would get more expensive too. This is one of the reasons why the decision to increase the interest rate isn’t an easy one.
Monetary policy is a complex topic and its long-term effects aren’t always foreseeable. Ultimately, though, the ECB chose to increase the interest rate in 2022 to fight price inflation in Germany and the European Union. So, measures are being taken at the policy level—now, what can you do personally to protect your money?
What you can do about inflation
No matter how much you’re affected by the current inflation, there are ways to protect your money—for instance, by investing in ETFs or company stocks, or buying your own apartment. This is one way you could make the most of your money. However, be aware that ETFs, stocks, cryptocurrencies and other investments are risky due to volatile market fluctuations. Don’t have enough budget to invest? That’s even more reason to take control of your finances! Start keeping a household budget or using handy tools such as N26 Insights to understand where your money goes every month. Chances are, you’ll discover opportunities to save, such as canceling unnecessary subscriptions, or spending less on groceries. Instead of driving alone, you could start carpooling with people from your local community. If possible, you could even ride a bike or use public transportation—with great benefits for the environment, too!
The bank account that gives you more control
Your money at N26
As high energy prices put a strain on your budget, you’re probably already doing a lot to reduce your energy consumption. However, there might be a tip or two from our guide to saving money on your gas bill that you haven’t heard of yet. If you find it hard to resist that third coffee on the go or a new pair of shoes, don’t worry: you can set daily spending and withdrawal limits with just a few taps in your N26 app. Or, use our N26 Spaces sub-accounts to automatically put some of your salary aside every month. This way, you won’t risk overspending and can start growing your emergency fund. Whatever you decide, your money is safe with N26. As a fully licensed bank, your N26 account is protected up to €100,000 by the German Deposit Protection Scheme. Compare our plans and discover how to budget with The Mobile Bank!
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