Did you know that over time, your money becomes less valuable? That’s right, every year that $1 in your wallet is worth less and less. How is this possible? It is all thanks to inflation. Because this is such an important concept to understand, I wrote this post about it, hoping to help you better understand inflation and how it effects your finances. Below is everything you ever wanted to know about understanding inflation.
What is Inflation?
The simplest way to describe inflation is that the purchasing power of the dollar decreases each year, or that prices rise each year. What costs $1.00 today will cost more next year based on the inflation rate, thus making your dollar less valuable. If inflation is 3% (which it historically is), then that $1.00 item will cost $1.03. While to a consumer the fact that you need to pay more each year to buy the same goods sounds bad, inflation is actually a good thing because it shows that an economy as a whole is growing.
As an economy grows, more jobs are created, meaning more people are working, higher wages, higher consumption etc. The tricky part about inflation though is keeping it under control. This is why you hear so much talk about The Federal Reserve raising or lowing interest rates. They are doing so in hopes to keep inflation in check. If the economy grows too quickly as does the resulting money supply, that could lead to hyperinflation, which is bad. Conversely, if a recession (or contraction in the growth of the economy) gets too harsh, the chances of deflation increase.
Hyperinflation is inflation on steroids. The economy grows too fast. Demand outweighs supply and businesses react by hiring workers and paying constantly higher wages. As the cycle progresses, prices for goods rapidly increases, leading to worthless currency. (I use the term worthless because as prices rise, small denomination bills cannot be used. Central banks begin to print large denomination bills.) No one wants to hold on to or save money because they need to buy goods before the price rises even more.
In the 1920’s, Germany was printing 2 trillion Mark banknotes. To put this into perspective, the exchange rate to US dollars was 1 Dollar to 4 trillion Mark. That means if you had $1 in US currency, you had 4 trillion in German currency. Again, this sounds great but realize that a postage stamp would cost you 50 billion Mark.
Deflation is the opposite of inflation. Instead of you needing more money to buy the same amount of goods next year, deflation allows you to buy more goods for the same amount of money next year. While this sounds great, it is actually very bad. In order to have deflation, an economy needs to have a greater supply of goods than there is demand for. When the supply is greater than demand, prices drop. Think of this like a sale at the grocery store on yogurt. The grocery store ordered more yogurt than there is demand for. In order to sell it all, the store drops the price. In a way, this is deflation, just on a very small scale.
When the demand for all goods drops, businesses will stop producing goods since there are too many of the items in the market, meaning workers will lose their jobs. This means less people will be buying goods since fewer have incomes now. For those with an income, they will delay purchases since prices continue to fall. On a greater scale, banks will stop lending money to consumers too. Why lend $100,000 to someone to buy a house and end up getting less at the end of the loan because prices keep dropping?
Furthermore, people with money will stop spending it. If you have $10 today, as prices drop, tomorrow you might be able to buy $20 worth of goods. Deflation is a dangerous cycle and everything is done to avoid it.
There is also the idea of hidden inflation. This type of inflation has taken advantage of you, you just might not realize it. Hidden inflation is when companies keep the price of an item the same, but lessen the quantity that you get.
A quick walk through the grocery store will show you countless examples of what I am talking about. A half gallon of orange juice costs $3.99 where I live. The only problem with this is that I am not buying half a gallon. A half gallon is 64 ounces. But the container of orange juice is only 58 ounces. So, while the price technically didn’t increase, it really did since I am getting less orange juice.
A few years ago, a picture went viral of a Subway foot-long sub. It turns out that a foot-long (12 inches) sub is only 11 inches. In one of the many stories I’ve read about this, they interviewed a franchise owner who talked about headquarters telling franchise owners to reduce the amount of meat they put on the subs. Before you might have had six slices of ham on your sub, but now you’ll only get four.
Hidden inflation is everywhere, so make sure you take your time when buying items, especially at the grocery store. Be sure to compare the unit prices of goods and not the price you see. The unit price will more accurately tell you the true cost of an item.
What Can You Do About Inflation?
Now that you understand inflation, is there anything you can do about it? Not really. Inflation happens on such a large scale that you as a consumer have very little (if any) control over it. But with that said, you can control the rate in which the value of your savings erodes from inflation.
As I noted above, the historical average rate of inflation is 3% per year. So, you want to make sure that you are earning at least 3% interest on your money. This will ensure that you are not losing money each year to inflation.
What are your options when it comes to earning 3% or more? For investing, this is easy. As long as you invest in the stock market (and stay invested for the long-term), you can expect an average rate of return of 8%.
For savings, like an emergency fund, things get a little trickier. About 10 years about you could have a savings account pay you 3%. Now, you are lucky if you can get 1%. But fear not. The change in interest rates moves in waves. This means that interest on savings account won’t always be as pathetic as they are now. In fact, the Federal Reserve is slowing raising rates as I type this.
The point here is to not get scared into taking on too much risk with your savings. Be happy with a 1% interest rate. It won’t be that low forever and your money is safe. But, you shouldn’t have all of your money in this account. You need some money invested in the stock market so that it can grow and you can afford to retire one day.
As you can see, inflation is an evil that we have to deal with. A steady inflation rate (again, historically around 3%) means that the economy is growing and that it is healthy. So while it isn’t the best that our money is losing value, the good news is that the economy is growing, which means jobs are plentiful, raises are happening and the stock marker is rising.
The Federal Reserve does all it can to keep inflation in check so that we don’t experience hyper or deflation, which are the two types of inflation we want to avoid at all costs.
Lastly, be aware and on the lookout for hidden inflation. The grocery store is the easiest place to see this, so make sure you are truly comparing apples to apples when looking at prices of two items.
Image courtesy of luigi diamanti / FreeDigitalPhotos.net