Understanding Inflation

Peter's picture

When we are planning a shift away from 9 to 5 work it is important to consider how our plans will stand up to the test of time. If you have ever seen an old Coca Cola sign saying "Ice Cold Coca Cola 5¢" then you've seen what inflation can do. If my financial plan 50 years ago was to put $5 under my mattress so that I could buy 100 bottles of Coca Cola today, I'd be in for a big surprise when I dropped into my local convenience store. Today I could probably only get 2 bottles with my $5. So to avoid running into a similar shock down the road, let's take a look at inflation to see what we need to do to deal with it.

We'll start things off with a diagram showing the main concepts and the we'll go over things in more detail.

Inflation: Here we see how inflation affects our ability to buy a $6 hammer with $10. By investing our $10 we maintain our purchasing power over time despite the effects of inflation.Inflation: Here we see how inflation affects our ability to buy a $6 hammer with $10. By investing our $10 we maintain our purchasing power over time despite the effects of inflation.

What is Inflation?

Inflation is the natural tendency for the cost of things to go up over time. There are several economic theories that try to explain why inflation happens but for our purposes today we just need to understand that it does happen. So gradually, all around us, the price of things is increasing. This means that the purchasing power of each dollar is going down over time. So to be able to afford our present standard of living in the future, we'll need more money than we do today.

We often talk about inflation "eroding our savings" or "cutting into our returns," but it is important to understand that inflation doesn't physically take our money. If you put a $100 bill under your mattress you will still have that $100 bill 20 years later. The problem is that that same $100 bill won't be able to buy as much as it did when we first put it under the mattress.

How High is Inflation?

Well, it is impossible to know for certain what the rate of inflation will be in the future, but typically an estimate of 3% each year is fair. So, $100 of stuff today will generally cost $103 next year. In some years inflation is higher than in others but for the purposes of our planning, an estimate of 3% should ensure that we don't run into any problems.

If you are interested in playing around with historical numbers, the Bank of Canada has an online inflation calculator that lets you see how inflation has affected the value of money over time. I just checked and $1000 in 1914 is about the same as $18,000 in 2007. So inflation definitely matters!

So Now What?

Now that we know that inflation can gradually erode the value of our money over time, what can we do about it? The number one thing that we can do is invest our money. We need to invest our money into something that will give us a higher rate of return than inflation. So although keeping your money under your mattress might seem safe, it isn't. Inflation steals a little bit each year as long as it is not invested.

A good rule of thumb when looking at a potential investment is to figure out your expected annual rate of return and subtract 3% to account for inflation. So, for example, a high interest savings account that pays 4% interest is giving you a total return of 1% after inflation. This ensures that $100 invested today retains its value so that in 10 years we'll still be able to buy the same amount of stuff that we could today. If a potential investment is paying less than our 3% inflation estimate then there is a risk that our money will grow more slowly than the cost of living. So if you've got all your money in a chequing account that pays 0.05% interest then you are at risk of losing out to inflation in the long run.

Inflation Matters

The main thing to remember is that you should not ignore the effects of inflation when you are putting together your escape plan. If you are creating an income generating portfolio you should aim for investments that increase their payouts by at least the level of inflation over time. By always considering the effects of inflation we can help ensure that our escape plan is built to stand the test of time.

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Comments

A few considerations: Always

A few considerations:

Always save at least 6 months salary no matter what. But make sure that 50% of it is saved in gold or silver.

But then:

If inflation is rising faster than your investments, then you have to really think whether it makes sense to invest your savings in such a low value return. One way to invest which will at least keep you at par with inflation is to invest in buying non-perishable goods that you will use in the future. One of the first things I would advise is to work up to having a year of food stored in your home. What other things will you use?? Toilet paper, shoes, clothing, other household supplies... Just make a list of what you buy and invest in more of it to store.

Be aware of this truth: Inflation is a tax that is hidden. It is imposed by your country's central banking organization by raising the amount of money in circulation. Many people think that demand / supply is what causes prices to rise. True sometimes, but don't be deluded. If there are true shortages of an item this may be true, but mostly shortages are FALSE and are made up to gouge more profits from the public. Most of the time, if there is a real demand, then the market will create enough suppliers who want to profit from that demand. Sometimes oversupply may lower prices, but real shortages are truly rare except in extreme cases like a natural disaster covering a very large area. Most of what you hear in the mainstream media is propaganda for the government or corporations. Make sure you use this knowledge to "filter" your understanding.

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A very nice article. It

A very nice article. It added to my understanding awesomely. One thing I want to add: If the governments / banking systems study Islamic Banking System they will find that the solution to their all problems. It has no interest but the best thing is that it eliminate Inflation 100% from the society. Unfortunately no Muslim country is applying it because the government won't be getting the allied benefits associated with the modern banking system which is based on interest. To study the Islamic Banking system, you can get books of Mr.Bakir AlSarhan ; a PhD scholar of Jordan basing in the UAE(Alain). Peace !

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