In general, inflation refers to the increase in prices for things and fall in the purchasing value of money. Over time, a certain amount of money will have a poorer buying power in the future, than it did today.
In other words, whether you’re buying your favourite Calbee Hot and Spicy chips or the latest Macbook, prices of goods and services 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.
Inflation can have an effect on a country’s economy, so countries pay close attention to inflation. They do so using metrics such as the Consumer Price Index (CPI), which measures the average price levels of a fixed basket of goods and services over time.
There are three types of inflation with different causes:
Cost-Push Inflation is when goods and services become costlier to produce over time. It 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 increase, 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 when a strong demand for goods and services drives prices up. This increase in demand could mean more people are spending more money, or there’s an increase in population sizes. It could also mean an increase in spending power, leading to the same people consuming more items.
In the case of the Covid-19 pandemic, high consumer demand combined with supply chain challenges have contributed to spiked inflation rates. The United States is experiencing inflation rates of 6.8%, its highest since the early 1980s.
In the Covid-19 era, consumers — cooped up at home whether due to lockdowns or travel restrictions — turned their spending power to purchasing goods. Given limited resources and production, it will result in higher selling prices since the same item is now considered more valuable.
The third cause of inflation is Monetary Inflation. This type of inflation refers to an increase in the supply of currency in the market. With more money in the system, the value (purchasing power) of each dollar decreases, which means we end up spending more dollars to pay for the same item we once purchased.
So how does inflation affect us?
Inflation affects our purchasing power.
Firstly, if salary increases do not keep pace with the average rate of 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 poorer, even if you didn’t buy anything more than the usual.
It also concerns how we plan for our retirement.
If you spend $2,000 a month today, and you assume you will still only need that same amount when you retire in 40 years’ time, 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, which translates to an inflation rate of 3%.
That means in 24 years, you will need $4,000 to maintain a similar quality of life you have with $2,000 today. You’d need to set aside $2 for every $1 you spend today.
It might not come intuitively, but inflation plays a covert role in our life choices and decisions. The cost of a HDB flat today is certainly not the same as it was decades ago, even if they’re of the same tier, size or location. University education that costs $100,000 today will cost a lot more when your newborn baby grows up some two decades later.
Read more: 3 Effective Ways To Hedge Against Inflation
Understanding inflation rates will guide how and where we plan our finances, in a bid to ensure our savings and investment at least grows at a pace that is neck and neck with inflation, if not surpassing it.
If inflation rates are high in your country, it likely is a reflection of 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 in the South American nation reached a mind-boggling 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.
Read more: Retirement Planning: Is S$1 Million Enough?