Analysis: Inflation can eat away at our salaries until we're earning double what we used to, but only able to buy half as much
The famous monetary economist Milton Friedman once likened inflation to taxation. His point was that governments will often take certain actions which induce inflation, and this inflation devalues people’s income. Inflation ends up taking money away from people the same way taxation does, just without the democratic process behind it. It is exactly because of its ability to deplete our purchasing power that we should be more aware of inflation.
Recent Eurostat data shows the upward trend in Ireland’s consumer prices over the last few years. It also shows that our increases to consumer prices are below the European Economic Area’s increases to consumer prices.
But does this mean we shouldn’t be worried about inflation? I’m not so sure. The average weekly earnings in Ireland increased from €863.70 in Q4 2021 to €900.26 in Q4 2022, an increase of 4.2%. Of course, increases in average earnings during this period should be treated as a good thing, but we must never assume that wages increase in isolation without inflation influencing their real value. This is because in order for wage growth to actually increase the real value of wages, it must outpace increases to consumer prices. Put more simply, the additional money is only of benefit if you can buy more things with it.
Using an inflation calculator, we can see that in the same time period as above, the value of a weekly wage of €863.70 in Q4 2021 would be €934.73 in Q4 2022, an increase of 8.2%. This means that the real value of the average weekly wage was still 4% worse off in Q4 of 2022 than it was the year before despite the 4.2% increase in wage growth.
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From RTÉ Radio 1's Today With Claire Byrne, how inflation is affecting your shopping basket
On top of that, we have had further inflation since then. You would now need to earn €976.71 a week in order to buy what you could have with that €863.70 in the final quarter of 2021, a 13.1% increase. It doesn't take an economist to notice that if inflation erodes the power of money like this, it poses a serious problem for people because their income can’t buy what it used to.
What’s worse is that wages can lag behind inflation because they are 'sticky’. Economic theory predicts that wages may not increase in line with inflation because wages tend to be agreed upon hourly rates or salaries which are set for the duration of contracts. This means employers don’t have to instantly pay their workers more because inflation has gone up. Alternatively, they can change the prices they charge for their goods and services with relative ease which means prices can change quicker than wages.
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From RTÉ Radio 1's News At One, RTÉ Economics Editor Robert Shortt assesses what Eurozone inflation rate of 5.3% will mean for prices and mortgages here
An issue which arises when inflation affects people’s income is it’s difficult to pinpoint who they should be frustrated with. This is because inflation is like a hangover; the point in time which you feel the damage of what has been done to you comes way after the point in time the damage was done. Inflation occurs when there is more money in the economy than there is goods and services being produced. Tax cuts, increased government spending and lowering interest rates are all textbook causes of inflation because they help inject more money into the economy without guaranteeing an immediate increase in production. They also share another common trait with drinking/hangovers in that they feel good at the time.
People will generally be happy when they are charged less tax or can take out a loan for a new car with lower interest payments, but they will be less pleased when when inflation catches up with their wages. What’s more, it’s very difficult to pinpoint the exact actions which led to inflation. The following graph shows that not all sectors are affected equally in terms of price change when it comes to inflation.
Sectors like fuel production and clothing have seen higher rates of inflation than the health or accommodation sectors. This is because money circulates disproportionately when it's spent in the economy. Different people buy different things which means the dynamics for supply and demand are different across sectors and prices don’t change symmetrically for different products. As a result, it’s quite hard to work out which policy initiatives cause which exact price changes.
But as difficult as that may be, understanding the determinants of inflation is vitally important because it means that we understand how to manage it. Left unmanaged, inflation can eat away at our salaries until we’re earning double what we used to, but only able to buy half as much.
The views expressed here are those of the author and do not represent or reflect the views of RTÉ
