Understand inflation: Why Saving Is Making You Broke
By: Kai K.
Tags: Money, Personal Finance, Money Management, Money Mindset

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I’m sure your grandmother and the crazy old cat lady in the neighborhood have complained about everything being more expensive than it used to be in the past. Although I understand you not wanting to believe the crazy old cat lady, she is actually right. Everything really is more expensive now. This is due to inflation. One of the prerequisites to becoming financially literate is to understand inflation.

Begin To Understand Inflation: Definition and Example

According to Oxford inflation is a general increase in the prices of services and goods in a particular country, resulting in a fall in the value of money .

So said simply, inflation means “today’s dollar will be worth 50 cents tomorrow” (not exactly but this will make the concept clear). I hope you see how devastating inflation can be to your savings. It can even impact the investment world.

Let’s say you invested in an ETF that averages 10% a year and you’ve done so for the last 30 years. In total, you have invested $180,000 (approximately $6,000 invested each year).

Without accounting for inflation your $180,000 would be equal to 1.19 million dollars.

But that’s not the reality. We must add the average inflation rate, let’s say it’s 8% (rare but possible). The growth rate of your investment, adjusted for inflation is now equal to 2 percent a year. Your investment after 30 years is worth 1.17 million dollars. I know that may not seem like a lot, but every single bit counts when it’s about your retirement.

Real Example of Inflation

But even so, inflation is actually worse than that. The example used was generalized 2%. But in reality, it works sort of like compound interest.

Here is an example:

$1,000 losing value at a 2% inflation rate EVERY YEAR for 30 years

At the end of the 30 years, the $1,000 would be almost equal to 1/2 of it’s initial value. This is what really happens when you JUST save money.

But the thing is you don’t feel it on a the day-to-day or even year-to-year basis.

And, the inflation rate varies tremendously depending on the country you live in. And the USA inflation rate is usually about 2% but in Venezuela, it’s about 438% (as of the time of this writing)

With that type of inflation, even a 100% return on a stock would not help you. Costs would rise way too quickly.

How Inflation Works

To understand inflation you have to understand that governments play a huge role in it. A government may choose to print more money and that will, in turn, increase inflation. But it is not the direct cause.

In short, there are two different ways inflation can happen. There can either be an increase in demand for products and services (usually due to an influx of cash, like printing more money for example, or government stimulus checks) or an increase in production costs.

Increase In Production costs

This happens when demand does not change, but the prices of raw materials and other types of essentials are increased.

For example, the cost of oil could increase meaning that companies that use that oil as fuel for transportation would have costs increase. To make up for this increase in costs, they would need to increase their prices. And that increase will be felt by the end consumer.

In this case, the cause is an increase in commodities pricing. Commodities can also change prices according to scarcity. For some reason, there is a shortage of wheat, for example, then the price of wheat goes up.

If you understand these aspects then you are close to understanding inflation.

When there is a strong demand for a certain type of product, and that demand is maintained for a certain of time, prices for that product increase. As an aftermath prices of other types of products can also be affected.

Demand can also increase when th e workforce of a country has an increase of cash or buying power. The level of consumer spending rises, which can lead to high demand for products and services.

And of course, if the demand rises the supply drops, which means prices rise even higher.

This is the principle of supply and demand.

Companies also play a role in inflation, they can raise prices simply because consumers are willing to pay the increased amount.

Conclusion

These are the most basic elements you need to know about inflation. Of course, there is more to know, but that will be covered in other posts. So the next time the crazy old cat lady in the neighborhood complains about rising prices, don’t run away. Sit there, tell her she’s right, and let her know simply why it happens. Have a specific topic you want to talk about? Let me know in the comments.