How inflation can affect consumer purchasing power
You’re probably well aware of how supply-and-demand works when it comes to things like the price of oil, or consumer products like iPhones and Air Jordans. More demand tends to create higher prices, and vice versa.
The same is true for money: The more dollars the Federal Reserve prints, the less each one is worth. Obviously, if there were only, say, a million dollars in the entire world, each one would be worth a lot more than if there were one billion.
This is what economists are talking about when they refer to inflation.
The dollar becomes inflated as its production begins diminishing its purchasing power. We see this every day in our experience as consumers. Twenty dollars doesn’t buy as many groceries as it did ten years ago.
Using the Consumer Price Index (CPI) inflation calculator, you can see that the U.S. dollar is worth about half what it was 30 years ago.
Aside from what inflation does to purchasing power, there are two other specific areas where you should understand inflation’s effects.
Inflation can be especially hard on your retirement-planning efforts because there are limits to how much money you can contribute annually. The dollar’s purchasing power can drop significantly in 30 years.
That can affect retirement savings.
Treasury notes and other government bonds can provide investors one main advantage: consistent returns year-after-year. While these amounts can be humble, if you crave security, they’re something to consider.
Unfortunately, as you’ve probably been able to guess by now, this means they could actually pay out less as inflation goes up.
To make matters worse, as inflation goes up, investors sometimes rush to sell their bonds. They want to take their money and put it into something that won’t depreciate in value year-after-year.
The only way the Treasury can combat this is by offering higher yields to make them more attractive, but doing so increases the interest rates for most mortgages.
When that happens, there are a few noteworthy consequences:
- The value of investments goes down
- The federal government needs to spend more on financing its debt
- Interest on the national debt goes up
These added expenses to the national budget need to be offset either by cutting the country’s discretionary budget or increasing taxes. The only other option is even more deficit-spending, which slows economic growth.
None of these things are good for the consumer.
Try not to let inflation diminish your savings
As you can see, inflation is often not a good thing for your savings. While some inflation is necessary to spur the economy as a whole, the effect is always the same for the individual consumer: their money is worth less.
Inflation doesn’t have to hurt your savings, though. By investing your money, you essentially trade savings for other type of assets, like stocks, or real estate. These investments tend to be less affected by inflation than cash sitting in a savings account.
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