Inflation: What It Is and How It Affects Your Money
Inflation generally refers to an increase in the overall price level of goods and services over time. When prices rise, the same amount of money may buy fewer goods or services than before.
What Is Inflation?
Inflation describes a broad increase in prices across an economy over a period of time. Individual prices do not all move in the same direction or by the same amount, but a sustained rise in overall prices can reduce the purchasing power of money.
If the prices of goods and services rise faster than the value or growth of your money, your money may gradually buy less over time.
How Inflation Affects Purchasing Power
Purchasing power refers to the amount of goods or services that a specific amount of money can buy. When prices increase, purchasing power can decline.
If a basket of everyday goods costs 100 today and later costs 110, the same 100 will no longer be enough to purchase the same basket. This is a simplified example and does not represent an actual inflation rate.
Why Does Inflation Occur?
Inflation can result from multiple economic factors. These may include changes in demand, production costs, supply conditions, wages, money and credit conditions, government policies and global events.
The causes and effects of inflation can vary depending on the economy and the specific period being considered.
Common Types of Inflation Pressures
- Demand-related pressure: Demand for goods and services may increase faster than available supply.
- Cost-related pressure: Higher costs for materials, energy, wages or transportation may contribute to higher prices.
- Supply disruptions: Shortages or disruptions can affect the availability and prices of goods.
- Imported inflation: Changes in global commodity prices or currency values can affect domestic prices.
Inflation and Savings
The effect of inflation on savings depends on how quickly the value of savings grows compared with changes in prices. If money earns a return that is lower than the rate at which prices rise, its purchasing power may decline over time.
This does not mean that every savings or investment product will outperform inflation. Different assets have different risks, costs and return characteristics.
Inflation and Investments
Investors often consider inflation when planning for long-term financial goals because future expenses may cost more than current expenses.
The impact of inflation can vary across asset classes. Market investments can fluctuate and may lose value, while returns are never guaranteed simply because an investment is intended to address inflation risk.
Nominal Return vs Real Return
A nominal return is generally the stated change in the value of an investment before adjusting for inflation. A real return considers the effect of changes in purchasing power.
If an investment grows by 8% during a period when prices rise by approximately 3%, the increase in purchasing power may be lower than the nominal 8% return. Actual calculations can be affected by timing, taxes, fees and the method used.
Can Inflation Be Negative?
A general and sustained decline in the overall price level is often referred to as deflation. Deflation can have different economic effects and may occur under different conditions than inflation.
What Investors and Savers May Consider
- Expected future expenses and financial goals.
- Investment time horizon.
- Potential growth of income and savings.
- Investment risks and possible losses.
- Fees, taxes and other costs.
- The difference between nominal and inflation-adjusted outcomes.
Key Takeaways
- Inflation generally refers to a broad rise in prices over time.
- Rising prices can reduce the purchasing power of money.
- The causes of inflation can include demand, costs and supply conditions.
- Inflation can affect the real value of savings and investment returns.
- Long-term financial planning may need to consider future changes in prices.
- Investment returns are not guaranteed and may not always exceed inflation.