If it feels like your dollar doesn’t go quite as far as it used to, you aren’t imagining it. The reason is inflation, which describes the gradual rise in prices and slow decline in purchasing power of your dollars over time. The impact of inflation may seem small in the short term, but over the course of years and decades, inflation can drastically erode the purchasing power of your savings. Here’s how to understand inflation and the steps you can take to protect the value of your money.
How Does Inflation Work?
According to the U.S. Department of the Treasury, inflation is the increase in the price of consumer goods and services over time. The rise in price is measured by the Consumer Price Index (CPI), which is published by the Bureau of Labor Statistics. CPI measures the prices of a basket of goods and services, such as health care, shelter, food, and transportation. An average of CPI readings from January 1967 to December 2017 shows prices rising 2.4 percent annually. To put it another way, a $100 dollar bill would be worth around $135 in 2017 dollars, while in 1967, the bill’s purchasing power was more than $60. The CPI rose slightly in the first half of 2017, as shown in the chart below.
How does it affect you?
When prices are rising rapidly, the real purchasing power of your money starts to decrease. Inflation is typically measured by comparing the same product or service bought at different times, in the same currency. Over time, prices change as costs for things like food, fuel, and housing increase, along with prices of manufactured goods like clothes, computers, and automobiles. These prices often don’t even need to be passed on to consumers, as companies pass on cost increases to retailers and manufacturers. But eventually, prices rise enough to start to erode the purchasing power of your savings. And that’s why it’s called inflation. There are different types of inflation, and the factors that drive them differ.
The impact of inflation on your money
Inflation is generally measured by taking the year-over-year percentage change in the prices of a representative set of U.S. consumer goods and comparing that figure to the previous year’s level. For example, if a can of Campbell’s soup is selling for $1.39, the Bureau of Labor Statistics (BLS) would measure the change over the past 12 months as a percentage change of 1.9 percent. That figure represents the actual change in price for that item; if that number is 0.3 percent higher this year than last year, then prices have risen by 2.9 percent.
How to track inflation using a graph
Like many people, you probably never heard the term inflation until recently. That’s because the phrase isn’t included in the common English lexicon. But inflation affects most people, whether you realize it or not. Imagine you save your money each week in a traditional bank account. Say inflation rates vary over the course of the year and year after year, which makes your money purchase less and less. Here are the inflation rates you’ll find when you go to the online banking service Web bank. You have two choices: Prevent inflation from taking hold by keeping a strict budget and having consistent savings plan to provide the money you need each month. Reduce inflation by taking advantage of earning interest on money held in a traditional bank account or investment accounts.
Over time, many goods and services become more expensive, in part because production costs go up as volume grows. The prices of these goods and services also rise as they get more competitive, so if you are on a shopping trip and are comparing prices, you may find the same item at different stores that sell for the same price. But don’t be surprised if you see different prices — sometimes called inflationary “shifting” — for the same item. The Consumer Price Index (CPI), a measure of the prices of a basket of goods and services that’s used to adjust the Social Security Administration’s cost-of-living adjustment, is the best tool to track consumer prices over time.
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What Is Hyperinflation?
What happens when inflation gets out of control? The most extreme form of hyperinflation occurs when the rate of inflation drastically outpaces the overall rate of growth in the economy, leaving the buying power of money dramatically diminished. Consider Argentina, in recent decades. While Argentina experienced consistent annual inflation in the tens of thousands, it’s worth noting that in 2002, the Argentinian peso lost 97% of its purchasing power in a single year. The devaluation was so bad that the only way to buy essentials was to barter or accept large, inflated discounts from stores and other retailers. At its worst, hyperinflation can leave even those who are relatively well off out in the cold.
What Is Stagflation?
Stagflation, in this case, means higher prices and lower consumer demand, and the combination of factors contributes to slowing economic growth. “If you put that in layman’s terms, you could say consumers are struggling, they’re getting higher prices for goods, they’re not spending as much on goods and services,” says Tony Nash, research director at the International Council of Shopping Centers. The problem is especially acute in the United States, where many goods are manufactured overseas and shipped across the country for distribution and delivery, which raises prices. The reason for higher prices on imported goods is “deflation,” meaning that their producers have devalued their currency to reduce their prices relative to the dollar.
What Causes Inflation?
The problem is that no one really knows exactly why inflation occurs. There are many factors that impact the economy, and cause changes in consumer prices. An increase in supply due to increased productivity could cause inflation. A rise in oil and gas prices could also cause inflation. Consumer products also have an impact on inflation. For example, the price of gasoline tends to rise over time as fuel prices fluctuate. The other most common causes of inflation are a change in the supply and demand for currency. At times, inflation is caused by higher wages for workers, which leads to greater inflation of the money supply.
Inflation is caused by the “demand” side of the equation. The economy often expands because people need and want more goods and services, such as cars, houses, and even food. But then, those extra cars, houses, and food end up costing more to make and deliver. Inflation is known as demand-pull inflation because the way it is created is by people demanding a greater quantity of a certain good or service than the sellers can meet with existing products and services in the marketplace. The result? Your dollar buys a smaller amount of the same thing over time, which ends up depressing the purchasing power of your money. Put simply, inflation is when there is more demand than there is supply for a good or service in the economy.
Cost-push inflation occurs when prices rise because of a shortage of supply. Such inflation typically results in higher costs for businesses to serve the public. For example, if a loaf of bread is $2 and there is no wheat to harvest and mill it, or if a brewer is being undercut by an imported product, cost-push inflation can result in an increase in the cost of bread. This price increase likely results in price increases for consumers, who are then asked to pay the higher prices. Of course, consumers are not the only ones affected by cost-push inflation. Inflation can also hurt businesses. Higher costs of inputs mean less profit, which means the businesses may stop buying new equipment, hire fewer people, and raise their prices. At the same time, consumers’ cost of living increases.
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