For today’s Financial Literacy Month lesson, we turn to inflation. It’s important to understand inflation for long-term saving and borrowing decisions.
Simply put, inflation refers to the rise of prices of goods and services. As these prices go up, the purchasing power of money decreases. So essentially, inflation makes your money worth less over time.
The inflation rate is expressed as a percentage. For the past 15 years or so, the U.S. inflation rate has fluctuated between 1.6 and 3.3 percent. Typically, central banks will try to keep inflation in a target range of 1-3%.
While inflation can be higher than 3% at any given time, it’s best to plan for 3% inflation when thinking about borrowing and saving.
What Causes Inflation
Inflation is a monetary phenomenon—as more money enters the economy, the purchasing power of each dollar decreases. Central banks control how much money is introduced to influence the rate of inflation and to prevent deflation (more on that below).
How Inflation Affects Your Money
Say you have $100 you can use to make purchases. Instead, you keep that $100 under your mattress for a year. If the inflation rate is 3% that year, then the $100 you held on to is worth 3% less—because of inflation, it will only buy $97 worth of goods in last year’s dollars.
If you put that $100 in a savings account that earns interest, you lose less purchasing power, and might even gain, depending on the interest rate you’re earning on your savings. If you only earn 1% interest, you’re still losing money if inflation is 3%. For you to actually gain wealth from your savings, the interest rate you earn must exceed the rate of inflation (3% in this case).
Debt is affected by inflation as well. If inflation makes your money worth less over time, it also makes your debt smaller. If you borrowed $10,000 10 years ago and made no payments since, you still owe the same amount in nominal dollars. But the $10,000 you borrowed 10 years ago will buy you fewer goods and services today than it used to. (Of course, you’re probably paying over 3% interest on your debt, so your total debt level would have gone up.)
Lenders will plan for inflation in the terms of a long-term loan, so if inflation is high, you can expect to pay more in interest on mortgages and the like. If inflation differs greatly from what lenders and borrowers anticipated, it can cause financial harm.
Hyperinflation occurs when inflation increases very rapidly. An example is post-WWI Germany. The economy spiraled out of control. Hyperinflation caused prices to soar—and German Marks were worth less and less. During the course of 1923, a loaf of bread went from costing 250 marks to billions of marks. The German government issued new currency, eventually printing bills worth 50,000,000,000,000 Marks! Naturally, this infusion of new money in the economy only caused inflation to get worse.
Times of hyperinflation are very dangerous for a country. No one will save money, and no one sensible would lend money that might be worthless tomorrow. Normal, healthy economic activity is impossible during hyperinflation.
Deflation is the opposite of inflation—the price of goods and services goes down. This makes your money worth more; at 3% deflation, the $100 under your mattress will buy $103 worth of goods next year.
You might think deflation could be a good thing—after all, who doesn’t like lower prices for goods?
The sellers of those goods, that’s who. Also, anyone who carries any debt will suffer under deflation. And it’s no coincidence that our periods of greatest deflation coincide with economic depressions. Because of the potential for economic depression and the pain caused to debt holders, the most economists prefer modest inflation to any amount of deflation.
The main things to remember with regard to inflation:
- Inflation makes the value of your money decline
- For long term savings, it’s best to earn more interest than the rate of inflation (typically 3%)
- Banks and creditors will adjust the rates they charge based on anticipated inflation
- Inflation may also impact “cost of living” pay raises for workers
Keep coming back to learn more all month long for more Financial Literacy Month material, and call us any time for personal, confidential debt counseling.