What is Inflation and Why Should it Matter to Me
What makes the value of a dollar?
What can a dollar buy? To be honest, it depends. While our currency has remained the same for years (dollar bills, nickels, quarters, etc.), the “value” of that currency is constantly changing. It’s why you might hear your grandparents say they remember paying 5¢ to go see a movie, or why a brand new Ford might have only cost $2,000 in the 1950s.
The change in the buying power of a dollar is referred to as inflation or deflation. Inflation is an increase in prices for goods and services, causing your purchasing power to decrease. For example, if you paid $1 last year for a candy bar, but this year the same candy bar costs $1.05, then the inflation rate was 5%. The opposite is true for deflation; if you bought a candy bar for $1 last year, and now pay $.95 for that same bar, the deflation rate was 5%.
Inflation is most often measured using the Consumer Price Index (CPI) published by the Bureau of Labor Statistics. It is based on the prices of a basket of common goods and services in urban parts of the country. Unfortunately, this statistic can be misleading. One area decreases, like housing, while another rises, like groceries or food.
Why is this important?
Imagine you are retired and have $100,000 in savings paying 2% interest; your nominal rate of return. Now let’s take inflation into account. If inflation is averaging 5% per year, that makes your real rate of return negative 3%. In other words, you’ve lost 3% rather than gained 2%. The buying power of your savings has dropped and you can now buy less with your savings, meaning you need more savings. Inflation can be very dangerous, especially for retirees. You need to be conscious of inflation when planning long term, because what you pay now is not guaranteed to buy you the same goods or services in the future.
Inflation might be misleading because it can be hidden. For example, if a refrigerator costs the same as it did 10 years ago, but it will only last half as long, you will wind up spending more because you will have to purchase a new refrigerator sooner. Another good place to spot hidden Inflation 27 inflation is the grocery store. Have you noticed the size of packages of food, like ketchup bottles, getting smaller over the years? The price may be the same, but you are getting less of the product. This is called “hidden inflation” because the price of a good or service may not change, but the quantity or quality does, thus costing you more.
Inflation is “felt” more than understood
We “feel” it when we see prices rising faster than our income, or go to the grocery store and come out knowing we bought more in the past for the same amount of money. Inflation is an important concept to remember when planning for your future, savings and investing.
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What does this mean to us?
As inflation increases, we may be tempted to decrease the amount of money we put into savings or investments to cover the increased costs for us to buy goods and services. This is one reason you should periodically revisit and adjust your spending plans.
Over time, this can amount to a great deal of money, and it could lower the standard of living for everyone if left unchecked. Inflation is serious and must be thought about. Not taking inflation into consideration when planning your retirement can be very dangerous.
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