So, in all of our talk about the economy and savings, one thing always comes up: Inflation. People always assume they know what it is; then they plan for a flat percentage and realize that their estimates were wrong. Today we’re going to answer some important questions about this monetary policy.

What is inflation? Long story short, inflation is a regular increase in how much different things cost. We’ve seen this throughout our whole lives; our grandparents talk about going to the movies for a dollar; we pay seven now. When this occurs, the value of the dollar increases. For example, after inflation occurs, the candy bar I bought for a dollar at the beginning of the year could theoretically cost $1.05, but I’m still only physically paying a dollar. Most countries keep a constant rate of approximately 2-3% a year. Think about that… the American dollar in 2010 was only 50 cents back in the 1960’s!

Why does it occur? Unless the economy stays stagnant (which it never does), inflation occurs. There is no way to prevent it from happening totally. The reason behind it differs based on the way that the economy is going.

  • If the economy is doing well: If the economy is doing well, it’s the basic principle of supply and demand. People are going to spend money that they have, but if there’s not enough of what they want going around, the prices are going to increase, thus propelling inflation. This is often referred to as Demand-Pull Inflation.
  • If the economy isn’t doing well: Inflation occurs in poor economies because companies often need to spend more in order to maintain production. More spending = higher prices.  This is usually referred to as Cost-Push Inflation.

Why doesn’t it go out of control? It is a very finicky thing, and the government has put measures in place in order that it doesn’t go out of control.

  • Monetary policy: The government controls, to a point, the caps on interest rates for loans and such. If these are allowed to go too high, it can cause inflation.
  • Wage and Price controls: The government caps the price of certain items and minimum wage is enforced.
  • Gold standard: Our country does not use this as much as it did anymore, but there is still a slight gold basis for our money.

How can I prepare for inflation effectively?  One of the biggest struggles that people have is protecting their investments during inflation. Retirees often feel this the most, having saved enough to keep their lifestyle had it been 10-15 years earlier. So, what can you do to make sure that doesn’t happen to you?

  • Watch inflation at the same time you watch your investments. A company can look like it’s booming, but it may just be inflation setting in. Make sure to compare and contrast.
  • Discover the real interest rate of your investments. This is calculated by subtracting the inflation rate from your rate of growth. If your growth is at 5%, but inflation is at 3%, your purchasing power (real interest rate) is only 2%.
  • Make sure you account for inflation. If you currently live on $20,000 a year, and you’re retiring in 10 years, you will need $26,000 a year to live (the average inflation is at 3%, and you’d rather overestimate then underestimate).
  • Consider annuities: Basically, you buy yourself a pension, guaranteeing yourself income over a certain number of years. This is good, just in case you outlive how much you saved for.