Inflation & Why Your Money Loses Value

Inflation is the silent thief that robs your savings while you sleep. It is the persistent increase in the general price level of goods and services over time — or more precisely, the decline in the purchasing power of your money. If you understand only one economic concept in your lifetime, let it be inflation, because it affects every financial decision you make.

What Causes Inflation?

Economists debate the causes endlessly, but the core mechanism is straightforward. The renowned economist Milton Friedman stated it plainly: "Inflation is always and everywhere a monetary phenomenon." When the money supply grows faster than the production of real goods and services, each unit of currency becomes worth less.

Think of it this way: if an economy has 100 goods and LKR 1,000 in circulation, each good costs about LKR 10. If the central bank doubles the money supply to LKR 2,000 while the number of goods stays at 100, each good now costs about LKR 20. The goods didn't become more valuable — the money became less valuable.

There are also demand-side and supply-side factors:

• Demand-pull inflation: Too much money chasing too few goods. Government stimulus checks, easy credit, and low interest rates can all drive this.
• Cost-push inflation: Rising costs of production (energy, raw materials, wages) push prices up. Sri Lanka experienced this acutely in 2022 when fuel and fertilizer shortages drove food prices to record levels.
• Expectations-driven inflation: When people expect prices to rise, they demand higher wages and raise prices preemptively, creating a self-fulfilling cycle.

Inflation in Sri Lanka: A Case Study

Sri Lanka provides one of the most vivid recent examples of how inflation devastates an economy and its people:

For ordinary Sri Lankans, these numbers translated into real suffering: the cost of a kilogram of rice doubled, cooking gas became unaffordable, and families that had saved for decades in fixed deposits watched their purchasing power evaporate. A family with LKR 5,000,000 in savings at the start of 2022 saw its real value (purchasing power) cut roughly in half by year's end.

The "2% Target" Myth

Most central banks, including the US Federal Reserve and the ECB, target 2% annual inflation — presenting it as a healthy, necessary feature of a well-functioning economy. But consider the math:

• At 2% annual inflation, your money loses half its value in 36 years.
• At 5% inflation (closer to Sri Lanka's long-term average), your money halves in just 14 years.
• At 10% inflation, it halves in only 7 years.

Central banks argue that mild inflation encourages spending (why save money that's losing value?) and makes debt easier to repay. Critics argue this is a policy that systematically punishes savers and rewards borrowers — particularly the largest borrower of all: the government.

How Inflation is Measured (and Why It's Often Understated)

Inflation is measured through price indices like the Consumer Price Index (CPI). In Sri Lanka, the Department of Census and Statistics publishes the Colombo Consumer Price Index (CCPI). But these measures have known limitations:

• Basket composition: The CPI measures a specific basket of goods that may not reflect your actual spending patterns.
• Quality adjustments (hedonic adjustments): If a car costs 20% more but has 20% more features, statisticians may record zero inflation. But your bank account is still 20% lighter.
• Substitution bias: If steak gets too expensive and people switch to chicken, the CPI may substitute chicken, masking the real price increase.
• Asset prices excluded: Housing, stocks, and land prices are largely excluded from CPI, yet these are where most money creation shows up. In Colombo, land prices have increased 500-800% in some areas over the past two decades — none of this appears in official inflation figures.

Why Governments Tolerate (and Even Prefer) Inflation

Governments are the largest debtors in any economy. Inflation reduces the real value of their debt — effectively taxing citizens through currency debasement rather than through explicit taxation. It is politically easier to inflate away debt than to raise taxes or cut spending. This is why no major government in history has voluntarily returned to a hard money standard once they've adopted fiat — the temptation of the printing press is simply too great.