What is Inflation?
The technical ring to the word “inflation” shouldn’t make it fearsome, especially since its meaning is pretty straightforward. Inflation, simply put, is the decrease in the value of money, brought about by the rise in price of everyday goods.
Why We Should Mind Inflation?
The average inflation rate over the last 10 years was 5.5%*. This means that the cost of goods rose at an average rate of 5.5% per year, over 10 years. Simultaneously, the value of money dropped by the same average of 5.5% per year, over the same 10 yr. period.
a. Inflation and Income
The first impact of inflation is on income.
If the cost of goods increase by 5.5% this year and our income remains the same, then we won’t be able to buy all that we did last year because our money will fall short of the value of the goods by 5.5%
To illustrate, given the following:
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Last year’s income = Ps. 100
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Cost of book last year = Ps. 100 |
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This year’s income = Ps. 100
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Cost of book this year given inflation= Ps. 105.50 |
Last year, for my Ps. 100 income, I bought a book. This year, for my Ps. 100 income, I will no longer be able to buy the book because its cost or price would have increased due to inflation by 5.5% to Ps. 105.5.
The lesson is simple: whether employed or engaged in business, our salary or business income should increase by at least the same rate as inflation. And that’s just to break even!
b. Inflation, Savings and Investments
A second impact of inflation is on savings and other investment instruments.
Most published interest rates and returns on investments do not account for inflation. If we have money in a traditional deposit account promising to pay a guaranteed return of 4%p.a., we’re really not getting 4% more out of our money.
Assuming the inflation trend above continues, then we can expect 5.5% of our money’s value to be eroded. And because we were only guaranteed a 4% return p.a. on our deposits, then in real terms we would end up losing 1.5% of our money’s original value. That is, 5.5% inflation less 4% return = 1.5% inflation or erosion value.
Given this, if we have money invested in the stock market, mutual funds or any other investment instruments, we should always account for inflation and its impact on our financial goals.
Stay tuned for the part two, Learning How to Beat Inflation.
