Saturday, November 19, 2011

All About Inflation

I'm not sure how many young adults really grasp the idea of inflation.  Most people who impulsively spend probably don't need to worry as much about inflation as those who save, but hopefully you have read some of my other posts and agree that it is beneficial to budget and keep some money for the future.

The unfortunate thing is that inflation will eat away at your savings.  I'll first explain some of the basic reasons why we have money before going into detail about inflation.

First of all, why do we have money?  What was the world like before money?  The boring academic definition of money is anything that acts as a medium of exchange, unit of account, and store of value.  Essentially, in the past, when you wanted to get something from someone, you had to offer something you had to trade.  If you were a carpenter and wanted food, you would try to find a farmer to trade shoes for vegetables and it would be quite costly finding one who needed shoes at the particular moment you needed food.  Thus, there is a strong need for a medium of exchange and in the past many things have been used.  Over time, it has evolved into strips of paper printed by the government.  Now we can exchange whatever we have for cash and use cash flexibly to buy whatever we need since it is almost universally accepted by everyone.

However, we can't forget that these strips of paper will always be just that.  The value they hold is only the value other people accept it as.  Of course, $1 will always be $1 but that doesn't tell us much in terms of its value.  It is better to think of the value of $1 in terms of how many apples it can buy, how much detergent it could buy, or how much of a standard basket of goods it can buy.  This last basket of goods is what is used to determine a measurement of inflation: the Consumer Price Index (CPI).  The basket contains food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services weighted to reflect reflect their importance in calculating the cost of living.

Inflation is a measurement of how much the general level of prices rise, specifically the consumer price index.  If last year you could have bought 10 "baskets" of the consumer price index and this year you can only buy 8, then inflation has decreased the value of the money you saved between those specific instances.  Of course, not every buys the exact basket determined by the U.S. Bureau of Labor and Statistics, so the actual effect of inflation may vary individual to individual, but the general essence of inflation is captured by this benchmark.

Currently, the expected 2011 inflation rate is around 3.5%.  Over the past 20 years, inflation has been around 2.5%.  This means that each year, about 2.5% of your purchasing power is getting eaten away by inflation.  Taking inflation into account, the 1% interest you may earn on your bank account would not even match the inflation.  How do you prevent your wealth from being inflated away?  You could try to invest more in real assets and buy physical goods that you expect to go up in price or buy financial assets with higher expected rates of return (i.e. stocks).  There are also government bonds called Treasury Inflation-Protected Securities (TIPS) which pays interested adjusted for inflation (meaning if inflation increases this year, you will get paid more to compensate for the loss of purchasing power).

It is important to realize that the number shown in your bank account may not represent the same value year to year, even if the number stays the same.  It is important to grow your money over time, at least by the rate of inflation if you want to maintain consistent wealth.  There are a lot of macroeconomic impacts that come with rising inflation or deflation, which I may discuss more in the future.  However, even on an individual level, it is important to recognize the costs associated with holding money and what could be attacking its value.

1 comment:

  1. As always comes with the great post i like your working standard and blogging sharing fantastic post there is a lot that i can learn!!