If you have ever held on to money for an extended period of time, you may have noticed the money being worth less. Perhaps you were saving money to buy a new phone, but when you checked the price again it went up by twenty dollars. Perhaps you noticed that, although your wages went up, prices increased much more dramatically. This is because of inflation. In this article, I will talk about what inflation is and how it affects people.
What is Inflation?
Inflation is a sustained increase in the price level for goods and services over a relatively lengthy period of time. The target inflation rate for the economy is 2%. If the price level only increases for a short period of time, that is not inflation, as inflation occurs over an extended period of time. An example of inflation, as shown by this calculator from CNN, is how $2000 in 1957 would be equivalent to $16,634 now.
You may have heard of Venezuela, the South American country, known for its political upheaval and hyperinflation. Venezuela is currently dealing with the effects of unrestrained, uncontrolled inflation. The economic situation is spiraling out of control. According to the IMF, cited in The Washington Post, “Venezuela’s hyperinflation is poised to reach an annualized rate of 1 million percent by year’s end.” To put the sheer magnitude of that inflation rate in perspective, locals sell artwork made up of thousands of Bolivar notes because they are essentially worthless. In the United States, the government and the Federal Reserve are responsible for preventing hyperinflation through fiscal and monetary policy.
How Inflation is Tracked
Inflation is tracked through the Consumer Price Index (CPI). The CPI tracks the changes in the cost of living over time.The CPI is a major index and is the one used by the government. Since the CPI calculates inflation, the government can use it to determine the economic policies needed to prevent inflation. Inflation is also tracked through the GDP Deflator, which is used to deflate the GDP to base year prices, indicating real output.
Each year, the inflation rate is an important factor for the government and other agencies tasked with protecting the economy, particularly economic advisors in the White House and the Federal Reserve. Inflation can often dictate whether or not the economy is overheating, and if necessary fiscal or monetary policy actions must be taken.
Inflation Effects on Borrowers and Lenders
Let’s say you take out a loan on a fixed interest rate. You expect the inflation to be 3%, but it actually is 5%. If you are the borrower that means that the amount of money you have to return is worth less, so it benefits you. However, if you are the lender, the amount of money you get back is worth less than the original amount so it is detrimental towards you. Similarly, if the expected inflation rate was at 3% but the inflation turns out to be 1%, the borrower would have to pay back more than he or she borrowed, benefiting the lender but not the borrower.
What truly matters is your real interest rate, which is the nominal rate adjusted for inflation. If there is more inflation than expected, the real rate decreases, and the borrower ends up owing less. If there is less inflation that expected, the real rate increases relatively, and the borrower ends up owing more. The lender receives a high payment than before.
How Inflation Affects Individuals and How to Protect Yourself
Inflation commonly affects people’s savings. Suppose you decide to save $100 and put it in a cupboard in your house. If the inflation rate is 2%, then a year later you would need $102 to buy the same amount of goods $100 would buy the year before. As a result, individuals should invest their savings so that their purchasing power will not decrease. Many investments will rise with inflated prices. There is an opportunity cost to not putting your money to work.
Inflation especially affects retired people, as they will not be receiving additional income anymore. According to Poonkulali Thangavelu from Investopedia, you can safeguard your money by investing your money in Treasury Inflation-Protected Securities, stocks, or mutual funds. Although those are riskier than a savings account, you are able to get a higher return. Furthermore, consumers should know that inflationcompounds when trying to calculate the inflation for the future.
In order to further protect yourself from inflation, you can invest your money into real estate. However, you should realize that you need to hold onto real estate for a couple years in order to see the prices increase by a sizable amount. Furthermore, you can invest your money into real assets like gold. You should also make sure that you are protecting your savings and getting the best interest rate from savings accounts and investments. If you manage to find a good deal, your money could have a higher interest rate than the inflation, causing your money to have more purchasing power over time. You want to avoid having your money depreciate. You should also attempt to hold a job where your raises increase at a faster rate than the inflation, through negotiating wages that reflect expected inflationary prospects in the future. If this is the case, then you will not succumb to inflation and you will preserve the purchasing power of your money at the same level or higher than before the inflation.
Next time your wages go up, think about if you really got a raise. If the price level in the economy increased by 5% but your wages only went up 3%, your money is worth less and you have less purchasing power. Make sure to see if your real wages went up, not only your nominal wages! Hopefully this lesson will have made you more educated in making borrowing and lending decisions. There are important steps that you can take to protect against inflationary pressures that have the potential to devalue the purchasing power of your money. Inflation an important macroeconomic concept and one that needs to be understood in order to make educated consumer and financial decisions.