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How To Understand Inflation And How It Devalues Your Money

By Edited Nov 13, 2013 0 0

Inflation can be stated in other terms as the decrease in the purchasing power of money over time.  The inflation rate is expressed in terms of a percentage of the loss in the value of a unit of currency with respect to the previous time period.  Most economists agree the primary cause of inflation is the increase in the quantity of the money supply.  If the supply of money grows faster than the growth of the economy, then a surplus will result and money will lose value. 


Inflation in of itself is not always a bad thing, in fact, there are some beneficial consequences from inflation. 


One resulting benefit of inflation includes relief for borrowers with fixed rate interest loans.  As the borrower makes repayments on the loan, he or she is actually paying less interest to the lender as inflation is present.  If for example, the borrower has a fixed interest rate of 9% and the current rate inflation is 4%, the actual total interest paid is 5% (9% - 4%).  This works well for borrowers but not so great for lenders and for this reason lenders offer and prefer borrowers to accept variable rate instead of fixed rate loans.  Another benefit, argued by economist James Tobin is that when consumers see their money is losing its value they will often pull money out of savings and invest it and help to encourage economic growth.  Also, as consumers see the value of their money decreasing, they are more inclined to make big ticket purchases sooner than later which can drive economic growth.


Inflation of course is not without drawbacks.  An obvious drawback includes rising prices of goods and services to accommodate a devaluing of currency, which costs businesses and consumers more.  Another drawback is that people often will begin to buy wealth commodities like gold to protect their assets while creating a shortage of that commodity and driving up its cost.  Hyperinflation is another ill effect that can result as inflation rates goes excessively high due to an increase in the money supply and a unit of currency can become worth less than half in as little as a month.  Hyperinflation causes serious problems to the inner workings of an economy and can even cause it to collapse.


So what does this mean for your money?  Financial author James Lowell states that in general you can expect the buying power of a $1 bill to reduce to 50% approximately every fifteen years.  This means that $10,000 in the year 1995 only buys half by 2010.  Of course in some years the inflation rate will be higher and other times lower, but if you take this value as a conservative average and run the numbers you will find that this comes to a yearly depreciation of your money of about 4.5%.  This may undoubtedly come across as a perilous statement, but it does not need to stir up fear.  Now that you are aware of inflation, its causes and how it directly affects you, you can take action.  Financial author, James Lowell states that the way to beat inflation is by growing your money faster than inflation can devalue it.  You can accomplish this by investing your money in the stock market through individual stocks and mutual funds.  Other investment vehicles may be appropriate for you in adding diversification, safety and flexibility, but realize that if they aren’t yielding a rate of return 4.5% or more, than you are going to lose ground against inflation.  Armed with this knowledge you can make wise financial choices to minimize the unavoidable effects of inflation on your money.





Inflation, From Wikipedia, The Free Encyclopedia



Lowell, James (2007).  Investing From Scratch: A Handbook For The Young Investor.  New York, New York: Penguin Group.



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