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July 25

How Inflation Works and Why It’s Important to Understand When Saving Money

Posted by on July 25, 2016 at 8:11 AM

Buckscoop is a money conscious blog that focuses its activities around saving money and getting better value on your purchases. Yet, a quick scan across our blog showed that there was little explanation about one of the biggest changes that happens to money as it ages, inflation. Most of us, including myself, have a good idea about saving money, but probably a little less about inflation and why stuff gets more expensive. Particularly when our salaries do not increase at the same rate.

How Inflation Works and Why It’s Important to Understand When Saving Money

There’s no denying it plays a fundamental role in our day-to-day finances affecting the cost of milk, how much you will earn and how healthy your retirement savings are. So, the aim of today is to provide a little more information around the subject of inflation to help you align your efforts to save money more effectively.

 

What is Inflation and How is it Measured?

Inflation on its own is simple enough to understand, it means the rate at which goods and services increase in value as a direct result how our dollar decreases in value. A good example: your morning coffee now costs $6 instead of $5, meaning your dollar buys less coffee than before. It’s the same coffee and the same dollar, but the dollar has less value.

Inflation can be measured and analysts use a metric called the Consumer Price Index (CPI), which basically looks at a basket of goods and services such as food, medical expenses, transport costs etc. and averages them out. This is done to give a general idea of how prices are changing over time.

Oil prices play a huge part in CPI because it is used to transport almost all goods and if transportation becomes cheaper, there is less cost associated with that product. If CPI goes up on a graph things in general will get more expensive, but if it stays level you will see prices remain at a similar level, but remember this is only an average, so whilst transport may remain the same, milk might increase.

How Inflation Works and Why It’s Important to Understand When Saving Money

 

How Inflation Affects You

How Inflation Works and Why It’s Important to Understand When Saving MoneyInflation doesn’t get a good wrap because it’s always mentioned in the news and is partially blamed for making us poorer or our money not going as far, but it’s not necessarily a bad thing.

When inflation is up it does make us feel the pinch, meaning we may resort to spending less after our necessities have been purchased, e.g. buy less expensive products, choose cheaper alternatives or hunt for more bargains. This kind of behaviour has been one of the driving forces behind ALDI’s success since the 2008 recession. Here are some deals that highlight this exact commercial behaviour:

 

When inflation is slow, as it has been for the past two years, we think it’s awesome. Petrol right now is cheap along with a bunch of other products like food products which haven’t increased too much either. Overall, this feeling that our money has more value puts a smile on our faces. Hence why the subject of inflation is seen in a negative light, because who really wants to pay more for the same products?

 

The Importance of Keeping up with Inflation

How Inflation Works and Why It’s Important to Understand When Saving MoneyIf your tactic recently has been to store cash under your mattress or in a sock then this is ok, but in times of inflation this is bad for your money because that $100 you stored won’t be worth the same $100 when you remove it 1 year later after a period of high inflation. Your savings won’t be earning interest, so your wealth isn’t keeping up with inflation and your savings are devaluing.

The lower the rate of inflation, the more money you earn from your interest rate, even if the bank only gives you 1% and inflation sits at 0.5% as it did in 2015. However, the figures aren’t great and it’s one of the main reasons why people look to invest their money.

Imagine you earn $40,000 per year and you plan to retire in 30 years and you want to have $1 million in your retirement account to live happily. That’s all well and good, but that $1 million will be exposed to inflation, which will actually mean you will need $3.24 million in thirty years for it to have the same value as $1 million does today.

There are thousands of sources online that will tell you how to invest your money to keep up with inflation, but I’m not going to bog you down with those, you can figure out what’s right for you. However, what I will mention is Treasury Indexed Bonds. They are low-risk investments and no, you wont earn a fortune from them, but they will help your money retain its value in line with CPI.

 

Inflation’s Balancing Act

How Inflation Works and Why It’s Important to Understand When Saving MoneyI love low petrol prices just as much as the next person but it’s not all good in the long term because economists around the world agree that inflation is healthy for the economy because it keeps it balanced. Inflation creates jobs for example, the government like it in small doses too and although it may devalue existing currencies a little bit, it encourages the government to poor more money into the system. That money gets used to invest, build, develop and hire more staff during the process.

Lower prices mean businesses suffer, people may lose their jobs and so they stop spending their money. If money runs out, people default on their loans and mortgages and then banks begin to struggle and the economy turns into emergency mode. This is called deflation and that’s exactly what happened in Japan during the ‘90s.

All things in life come down to balance and whilst inflation can be perceived as bad in the short term, it’s the long term that it really provides benefit. Without it, there would be huge systematic long-term problems that could collapse the capitalist system we have built around us.


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