You hear people moan about it all the time. “Must be inflation,” is said quite often by the guys at the office. But what exactly is inflation, and more importantly, how does it affect your finances? While inflation is mostly a concern for economists, it’s also something you can and should know a few things about. Here’s your primer on inflation -- what it is, how it affects you and how to guard against it.
what is inflation?
Simply put, inflation is an increase in the average level of prices over time. While it usually happens slowly, it can occur overnight, which is both unusual and catastrophic for the economy. Generally speaking, there will always be inflation, so the worry of the government is not how to stop it, which is impossible, but how to keep it at a steady, manageable pace. Likewise, your concern shouldn’t be whether inflation is there, but how to stay ahead of the curve.The best way to understand inflation is with an example, for which I’ll use a CNN.Money.com calculator. The tool was built to measure the inflation of children’s allowances, but it can be used for anything -- let’s say a pint of beer costs $5. That might seem like a good price to you, but how do you know if you’re overpaying or getting a deal?
Using the calculator, you discover that 20 years ago the same beer would’ve cost you $2.81. In other words, the price of beer has almost doubled in the past two decades. Now, here’s the fun part. Let’s say you make $40,000 a year; 20 years ago, your salary would have been $22,446.81. If you divide your salary by the price of a beer, you’ll learn that at $5 a pint, you’re better off than you were 20 years ago. Today, you can buy 8,000 pints, whereas 20 years ago, you could only buy 7,988. So, historically speaking, $5 is a good price for a pint because you get more today than you did then. That’s why we measure inflation, and that’s how you know if you’re getting a good deal.
how is inflation measured?
Inflation is measured by the government using the Consumer Price Index (CPI). Economists commonly refer to the CPI as the change over time in the price paid for a basket of goods, which means that it’s a representative list of things the average person needs to buy on a regular basis. The list includes food, housing, clothing, medical costs, transportation, recreation, education, and miscellaneous expenses. However, the list excludes investments, such as bonds and stocks.For the typical guy, the list will give an average picture of rising or falling prices. The trouble is that there’s no such thing as the “typical” guy. The CPI will only tell you that the nation is suffering from inflation; it won’t say precisely how you are affected. To determine that, you need to know how much you paid for goods and services in previous months.
For example, take a look at your fuel bill: The CPI may indicate that there is a 1% jump in the price of gas, but that doesn’t really mean anything to you until you check your own numbers. If you’re paying 5% more for gas than you were a few months ago, you’re suffering at what is likely the higher end of the gas inflation scale. But gas is just one example. One way to be certain that you’re keeping your expenses in line is to check your totals against the national averages. You won’t be able to stop your costs from rising, but if you can keep your costs from growing faster than the rest of the country’s, you’ll be ahead of the game.
what causes inflation?
Virtually every major economist has a theory about what causes inflation, from increasing demand for goods, which pulls prices up, to decreasing supply, which causes scarcity and also drives prices up. The truth is that all the theories are right in some ways and wrong in others. But none of that matters much when you’re the guy caught in the throes of inflation. For the individual, inflationary spikes -- no matter what the cause -- mean only one thing: trouble.You’ll see prices jump on everything from food to gas, but don’t expect help from your boss. His costs will go up too, which means your wages will likely stay the same. But there is something you can do: Get a new savings account. Interest rates typically rise with inflation -- though not as much. The trouble is that few banks do you the favor of offering you the higher yield. If you open a new savings account, however, you’ll get the most recent rate. Likewise, if you have money to invest, an inflationary period is a good time for bonds.
what is deflation?
Deflation is the exact opposite of inflation. In other words, it’s a drop in prices. While it may sound great, it’s not the best news because it typically means that the value of everything you own could fall. So what should you do when there’s deflation? For starters, it’s probably not the time to get a new job because you’ll likely have to take a pay cut -- it’s one of those times where you need to focus on staying where you are and justifying your salary. Assuming you can do that, the next thing you should do is take advantage of the drop in prices. If you can afford it, this is the time to buy a home because you’re timing the market. Not only will you get a good deal on the price of the house, but you should also be able to lock in a low mortgage rate.beating inflation
The simple truth is that no matter how hard you try, you’ll never avoid the adverse effects of inflation. But that doesn’t mean you should give up. In fact, it means that you should work as hard as you can to educate yourself on the matter. Why? Well, with billions of dollars on the line, major investment banks employ armies of economists just to track inflation. Of course, those companies can afford to lose a few million if the economy turns south. But for you, an economic downturn could be catastrophic. Knowing what inflation is, how it works and how you can limit its effects could help you keep your finances safe if the economy tanks.Resources:
http://economics.about.com/od/helpforeconomicsstudents/f/inflation.htm
http://cgi.money.cnn.com/tools/allowance/allowance_101.html
http://www.bls.gov/cpi/cpifaq.htm#Question_1
http://inflationdata.com/Inflation/Inflation_Rate/CurrentInflation.asp
http://en.wikipedia.org/wiki/Inflation
http://www.smartmoney.com/ask/index.cfm?story=19981102
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