Inflation's Impact On Your Money

Do you ever wonder why the cost of our stuff always seems to go up? For example, when I was growing up a postage stamp (do people still know what these are?) was 25 cents. Now they cost 49 cents. A candy bar was 50 cents. I now sound exactly like my grandparents who used to exclaim that "a Coke used to cost a dime!"

The reason prices go up is something called inflation. That's not all that interesting. But how inflation impacts our money, that deserves some attention.

Inflation

Inflation is a term given to the situation where prices go up. That's it. Prices go up = inflation. Inflation applies to the prices all all goods and services, and there are as many ways to measure it as you can think of. The most common is the consumer price index, or CPI, but there is a producer price index, and an index of different industries and geographic areas. 

Let's make this easy. Inflation, no matter how it's measured, is when the price of our stuff goes up. 

Causes

When I was in college I learned really quickly that the answer to almost every question in economics is "supply and demand" (the other common answers are "trade offs" and "opportunity cost"). Thus, the reason for inflation is supply and demand. 

Prices of our stuff can go higher because the demand for stuff went up faster than that stuff could be supplied. The jargon for this is demand-pull.

Alternatively, prices of stuff could go up because cost of doing business went up. In other words, the cost of production or inputs went up; things like wages and energy. Producers need to charge more to cover their costs in this case. The jargony word here is supply-push. 

This is slightly advanced, but just know that there are reasons for inflation that are being measured and monitored. 

Nominal Vs. Real

This is a little technical, but I think it is important. When people (namely, economists) use the word "nominal" they mean the most common definition of the words they use. So, a nominal rate of return is the actual return you earned. If you had $1,000 and your nominal return was 5%, you now have $1,050 (1,000 x 1.05). 

In the real world (no pun intended), nominal is not very useful. Having your money grow from $1,000 to $1,050 says nothing about how much stuff you can buy. What if the stuff you want to buy went up $1,000 to $1,060? That's not as good. The way we measure our money over time while keeping an eye on how much stuff we can buy is to compare our return to the inflation rate. Technically this is called a real return, or an inflation-adjusted return. 

No Risk Doesn't Exist

The goal is to earn positive real returns. Allow me to translate that sentence. We want to earn returns that are higher than the rate of inflation. That way we earn money, even after inflation. If we earn a return that is that same as inflation, we get a zero real return and we are in the same place we started in terms of how much stuff we can buy (this is called purchasing power). But, it is possible to earn a positive nominal return (i.e. you earned 2%) but still have a negative real return (i.e. inflation was 3%). 

This is important because I've talked to and read about many people who have been scared away from the stock markets after the Great Recession a decade ago. Many of these people are millennials who had their first experience with stock investing at exactly the wrong time. Many of these people save money, but they save the money in a bank account that earns next to nothing. They say they don't want to put their money at risk because they believe they lost everything they had in 2008-2009, or they watched their parents suffer through the stress of a severe down market. 

But there is no such thing as no-risk; there is only a choice between what kind of risk you face. By not subjecting your money to market risk (the risk of prices falling when you need to sell), you subject yourself to a lot of inflation risk - or the risk that you will not make enough to keep up with inflation. 

I know it seems riskier, but by taking appropriate risks you can make sure your money grows even after taking inflation into account. 

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