Inflation refers to the increase in prices for things and fall in the purchasing value of money in general. In other words, whether you’re buying your favourite Calbee Hot and Spicy chips or the latest Macbook, the prices have gone up.
The $1.50 that you hold in your hand has lost its value in the sense that it can no longer buy the same bag of potato chips that it once could.
There are three types of inflation with different causes:
Cost-Push inflation is caused by an increase in the cost of producing an item such as manpower costs or raw material costs. When the prices of the components increases, the overall cost of producing the final item increases, this is then reflected in the increased selling price to buyers, such as ourselves.
Demand-Pull inflation is an increase in prices caused by an increase in demand for the item. This increase in demand could mean more people are spending more money, or there’s an increase in population.
It could also mean an increase in spending power, leading to the same people consuming more items. When this happens, while there are limited resources and production, it will result in higher selling prices as the same item now is considered more valuable.
So how does inflation affect us?
First, if salary increases are not in line with the average inflation of the country, you will end up having “less money” to spend over time. This is because the rise in prices for things is faster than the increase in your salary. You end up being broke even if you didn’t buy anything more than the usual.
If you spend $2000/month today and you think you will need $2000/month when you retire in 40 years, then you’ve underestimated the effects of inflation. On average, the effect of inflation reduces the value of each dollar by half every 24 years (3% inflation rate).
That means in 24 years, you will need $4000 to live like you do with $2000 today. This means that you need to set aside $2 for every $1 you spend today.
If inflation rates are high in your country, it likely reflects the stability of the country’s currency. When people lose faith in a currency, the exchange rates to other more stable currencies will fall. In other words, the currency is worth a lot less on a global scale.
In extreme cases, a country may even abandon their currency for a foreign one altogether, like the recent situation in Venezuela. According to a study by the opposition-controlled National Assembly, the annual inflation rate reached 1,300,000% in the 12 months up to November 2018.
Ultimately, it’s important to know that the money you hold in your hands right now doesn’t remain the same because of inflation. It’s essential to keep this in mind the next time you’re planning your savings or negotiating for a pay increment.