One of financial realities that many forget to consider is inflation. This is because inflation is relatively sneaky. You don’t see it in your taxes, and you don’t write a separate check for it. Instead, inflation manifests itself as a subtle reduction in your purchasing power. Think about what you could buy with $5 10 years ago compared to what $5 will get you today. I remember when you could buy penny candies and when gas was right around $1 a gallon. Those days are long gone — thanks to inflation.
What is Inflation?
Simply put, inflation is the way that prices rise over time. Inflation is usually described as rising prices, or a decline in the value of dollars. Either way, your purchasing power is eroded and you have to spend more money to get the same amount. In some cases, such as with packaged food, you spend the same amount of money to get a smaller quantity. No matter how you look at it, inflation makes sure that your money doesn’t go as far as it used to.
There is no universal agreement on what causes inflation. There are some theories floating around, though. Some of the things that likely contribute to inflation include:
- High Demand: If there is a great demand for something, but not enough supply to meet that demand, prices rise on what is available.
- Increased Costs: Businesses that see increased costs are likely to pass those on in order to maintain profit margins. These costs can include increased cost of benefits, higher wages for employees and costlier imports.
- Too Much Money: We have a fiat currency, rather than one that is based on something tangible. People talk about monetary policymakers “printing money.” The increases in one country’s money supply decreases its value and hence the cost of goods from other countries will become more expensive, leading to higher prices.
- Easy Credit: The ability to access credit can also contribute to higher prices, since being able to buy more expensive items with borrowed money can mean that it is possible for merchants to raise prices. After all, who cares about price increases when customers aren’t sensitive to affordability?
Whatever the causes of inflation, its effects can be very real, and affect you in the future.
Inflation Affects Your Finances
Obviously, when prices rise you feel it in your pocketbook. You have probably noticed changes in your budget due to recently rising food and gas prices. When you have to spend more money on things that you need, it is harder to find discretionary income for things that you want. Inflation can make it difficult to make ends meet — especially if wages haven’t kept pace with inflation (as has been the case in recent years).
When planning for retirement, it is important to factor in the effects of inflation. You might think that you will be fine if you save up $1 million, but the fact of the matter is that $1 million will not go as far in 30 years as it does right now. You might need to adjust your expectations, and your retirement savings plan, to cope with this reality. Health care, food and energy are items that are sure to rise in the future. Other items are also likely to cost more down the road.
As you prepare for the future, consider what you can do to protect yourself from inflation. This can mean diversifying your investments so that you get better returns, or engaging in other measures meant to protect you from inflation. Because inflation is inevitable, it is vital that you consider it when making financial calculations.