What Is Inflation? (Why Does it Matter?)

What is inflation?

Ever catch yourself saying “Man, I remember when you could get a burger for a dollar?”

Then you, my friend, have got the basic gist of inflation. Stuff gets more expensive over time – it’s sad but true. I think back wistfully to when petrol cost less than $2 a litre or you could buy a house for less than half a million where I live – fill in the blanks to suit your situation!

I remember getting into a bit of a debate with someone years ago about whether employees should get annual cost-of-living raises. If not, I reasoned, then they’re actually worse off financially every year!

That was probably the first time I ever really gave the concept of inflation any thought at all. But as I’ve gotten more financially savvy over time, well, the more I find myself thinking about this ‘silent thief’.

First things first: what the heck is inflation, seriously?

Inflation refers to a situation where something costs more today than it used to. And the more things cost, the less your money buys over time.

Let’s take a common item: the much maligned latte. Maybe you used to pay $4 for one, but now the going rate is $5. The product is the same; nothing’s changed except that your dollars buy you less of it than they used to.

What causes inflation?

Inflation occurs when demand for goods and services grows. As more people buy stuff, sellers increase their prices.

When consumer confidence is high (ie Average Joe is feeling positive about the future in terms of personal finances – typically when unemployment rates are low and wages are on the rise) we’re more likely to spend money.

As demand for something increases, the available supply generally decreases, and so people are willing to pay more for it. Most resources are, after all, finite. Sometimes a natural disaster that wreaks havoc on crops can drive up food prices. Or, during a building boom, the cost of materials might rise as supplies dwindle.

Rising production costs can also contribute to inflation. Maintaining profit margins is key to the survival of any business; companies can also choose to raise prices any time if there’s enough demand from the market and people are willing to pay a higher amount.

Inflation can also come about when there’s excess cash circulating around in the economy. If too much money is printed, it becomes less valuable. Hyperinflation typically takes place when governments print money to pay for wars, as has previously happened in Germany and Zimbabwe.

How is inflation measured?

Odds are you’ve heard of the consumer price index at some point. The CPI is probably the most common tool used to track inflation. It measures changes in the prices paid by consumers for a basket of goods and services, from consumables to transport to medical expenses, and averages them out. This gives a rough idea of how prices are changing; when the CPI goes up, inflation is at play.

(There’s also the Core Inflation Rate, which measures essentially the same thing but excludes food and fuel costs. Why? Food and energy prices are the most volatile – however, they are also a major part of any household budget. These costs often rise faster than other things – and significantly impact your bottom line.)

As Miranda Marquit at Good Financial Cents points out, you can actually track inflation on your own:

Take a look at what you normally spend money on. Choose a certain day each month to check the prices of these items and create your own measure. You can watch your personal inflation index for trends in prices. If you use public transportation, gas prices aren’t going to figure heavily into your personal inflation measure. If you have a newborn, and need to buy diapers, that measure will be an important part of your personal inflation measure.

You can compare your personal inflation measure to CPI and to core inflation. This will give you an idea of how accurate – how “real” – the wider statistics are for you.

- Miranda Marquit @ Good Financial Cents

How does inflation affect us day-to-day?

Well, according to Vox, both wages and prices have risen pretty slowly in the 21st century, so we’ve only seen very small increases in our living standards. Low and stable inflation lets us live our daily lives without giving inflation a second thought.

See, inflation naturally plays a significant role in everyday life; here are some examples of how it impacts your daily finances.

Higher prices: as we’ve already established, inflation means you wind up paying more for the things you buy, from shoes to booze to books. If your salary doesn’t keep up with inflation, you won’t be able to afford to maintain your current expenditure.

Interest rates: if your savings account is earning a lower rate of return than the current rate of inflation, then the value of that money is actually declining over time. When inflation is high, interest rates rise. Higher interest rates on home loans, personal loans and credit cards can put a big squeeze on borrowers.

The only winners in times of inflation are people in debt. The amount they owe doesn’t change, but the value of that amount is technically lower thanks to inflation.

However there are positives to inflation, from a broader economic perspective. According to Pat at Money Crashers, economists generally argue that some inflation is a good thing. A healthy rate of inflation is considered to be approximately 2-3% per year and the goal is for inflation to slightly outpace the growth of the underlying economy (measured by Gross Domestic Product, or GDP) per year.

A healthy rate of inflation is considered a positive because it results in increasing wages and corporate profitability and keeps capital flowing in a presumably growing economy. As long as things are moving in relative unison, inflation will not be detrimental.

Another way of looking at small amounts of inflation is that it encourages consumption. For example, if you wanted to buy a specific item, and knew that the price of it would rise by 2-3% in a year, you would be encouraged to buy it now. Thus, inflation can encourage consumption which can in turn further stimulate the economy and create more jobs.

- Money Crashers Pat Street @

What can we do about it?

Sadly, we can’t stop the costs of goods and services going up over time. But we can factor this into our own financial planning.

When inflation is on the rise, it pays to do all you can to keep your income sources growing too in order to outpace the rate of inflation. When inflation is low and prices fall or hold steady, look to increase your savings rather than default to buying more things.

As Life In Charge’s Jeffrey James says:

You should care about inflation because you want to keep as much of what you earn as possible … You either need to figure out how to increase your income, or spend less to compensate. But if you’re like many people, your income isn’t changing, and you aren’t changing your spending habits. That means you probably aren’t saving as much as you want to. And that can be a problem down the road.

- Jeffrey James @ Life In Charge

The most important thing to remember is that investing is the best way to beat inflation in the long haul. If your plan is to simply save, save, save … you might be in for an unpleasant surprise.

This is perfectly illustrated by The College Investor, who writes:

I know the story of a woman who was totally diligent her entire life and saved 20% of her income every year. She put it into a money market account. However, now that she is looking to retire, she has discovered that she doesn’t have nearly enough money because it never really grew over time. When I asked her why she saved and never invested, her answer was “I didn’t want to lose any money” but because of her fear of investing, she lost out on the growth of her money as well!

- Robert Farrington @ The College Investor

Inflation will eat away at your returns. Let’s say your portfolio is earning 7% annually, but inflation is running at 4%. You’re actually only coming out ahead by 3%. And if your returns are lower than the rate of inflation, then in reality you’re making a loss.

Investing can be intimidating, and yes, you do risk losing money in the market. But as you can see, if interest rates don’t keep up with inflation, then your precious savings are basically guaranteed to lose their value.

So by all means, save more! And then take some of that cash and move on to investing more aggressively.

In the long run, stock market returns have generally stayed ahead of inflation; for instance, the average annual return for the S&P 500 index (considered to be a good representation of the US stock market) is just under 10%.

Real estate may also be a worthwhile investment option to consider. Inflation will be on your side, as you’ll eventually be paying down that mortgage with dollars that are worth less than they are today. Land and home values tend to rise over time, although just as with shares, prices can fluctuate.

But possibly the best investment of all to make is in your own earning power. Betting on yourself is your best shot at inflation-proofing your income, whether that means going down the route of formal education, or taking it upon yourself to upskill. The more you can do to enhance your employability and cultivate skills that are in-demand, the better your odds of commanding good compensation and protecting your career from the whims of the industry or the economy at large.

In summary

While you can’t control inflation, you can account for it when planning ahead and making decisions about money. Given the huge impact that inflation has in the long run, it’s especially important to account for it when it comes to retirement savings and your long-term financial future.