Understanding Inflation and Its Impact on Purchasing Power

When prices rise above 3% generally, it is considered inflation – a matter of concern for policymakers. Inflation decreases the purchasing power of money, meaning that while something might have cost $2 two years ago, you might now have to pay $4 for the same item.

Inflation - The Basics

Inflation is defined as the rate at which the general level of prices for goods and services increases, leading to a decrease in the purchasing power of money. Each unit of currency buys fewer goods and services over time, which can affect savings, investments, and living costs.

Inflation in Context

To illustrate, consider the following changes in prices over the last two decades:

House prices: 2003: $198,000 2013: $273,000 2023: $423,000 New car prices: 2003: $22,000 2013: $32,000 2023: $48,000

Inflation is a critical factor to understand. While skills and income need to be built each year, it's also essential to understand how inflation operates. Inflation occurs when increased demand for goods and services exceeds their supply. This leads to rising prices, which in turn prompts people to expect wage increases, eventually increasing money supply in the economy.

Why Inflation Occurs

Inflation happens primarily because demand for goods and services increases without a proportional increase in supply. To address this, people often expect their wages to rise, which in turn increases the money supply in the economy. When inflation is persistent, it leads to the erosion of the value of currency, as it depreciates.

Impact on Purchasing Power

Directly, inflation can erode purchasing power over time. As the value of money decreases, consumers can buy fewer goods with the same amount of money, reducing their purchasing power.

Countering Inflation

To combat inflation, you can:

Diversify Wealth: Invest across different asset classes. Choose industries that outperform during economic downturns. Plan Expenses: Create a budget and allocate money for future expenses and contingencies. Save any discretionary spending for better times.

By understanding and mitigating the impact of inflation, you can better ensure your long-term financial health.