Inflation explained in 5 questions

What is inflation?

Inflation means that money loses value. In other words, the same euro buys you less today than it did a year ago. While such a change may not seem very dramatic over the course of a single month, over several years the effect can be significant.

How does inflation affect our daily lives?

Consider your weekly shop, a meal out or filling up your car with petrol. Prices rise gradually but significantly. Something that cost €100 five years ago may now cost €120 or more. This means your purchasing power declines. In other words, you get less for the same amount of money.

What causes inflation?

Inflation occurs when demand for goods exceeds supply. This may be due to an increase in demand (a demand shock), a drop in supply (a supply shock), or a combination of both. There may be several reasons for this, such as:

• A rise in energy prices caused by a reduction in the supply of oil and gas, as is currently the case.
• Disruptions in the supply chain (reduced supply), as was the case during the Covid pandemic.
• A very strong increase in demand at a time when the economy is recovering but supply cannot keep up.

The hidden danger: the savings in your savings account

Inflation is sometimes called the silent killer of our money. It gradually erodes our purchasing power without making a sound. Anyone who leaves money in a savings account that doesn't pay interest, or in an account with an interest rate below the level of inflation, will lose purchasing power, even if the account balance remains the same. With annual inflation of 4%, your money will lose around half of its value after approximately 17 years. This is where the 'rule of 70' comes in: divide 70 by the inflation rate to find out how many years it will take for your purchasing power to halve. With inflation at 10%, for example, your purchasing power would be halved within seven years. In practical terms, this means that the same amount of money will only buy half as many products and services as it can today.

How can you protect yourself against inflation?

To protect your purchasing power, you need to consider options beyond your savings account. Investments, property and specific products such as inflation-linked bonds can help to maintain the value of your assets. If you take out a loan to buy a property, high inflation can benefit you in two ways. Firstly, the value of your home tends to rise in line with inflation. Secondly, salary indexation makes it easier to repay your fixed monthly instalments year after year.

Is inflation always bad news?

No. A low inflation rate of around 2% per year is healthy for an economy: it encourages consumption and investment. Companies see their selling prices rise by around 2% each year, which increases their return on investment. Households are more inclined to spend because products may become more expensive tomorrow. It is only when inflation becomes high or unpredictable that it significantly affects purchasing power and confidence.