What is inflation? Is it really important?

simple stepsInflation is a persistent increase in general prices in an economy which results in a loss of purchasing power.

The effect of price increases is insidious because we remember what the price was a short time ago, but not prices longer ago. Let’s take a look at both how prices have gone up and the loss of purchasing power together.

Why a loss of purchasing power? Consider the historical price of gas, or historical price of stamps, over the years. Thus, when a gallon of gas or a stamp costs more, this means you get less for the same dollar. Or stated another way, it now takes more dollars and cents to get what you used to get for fewer dollars and cents – it takes more dollars to buy the same. Your dollar has lost purchasing power.

The effect is this … more dollars for something you need means fewer dollars to spend on something else you need.

One would think that falling prices would be better. This is called deflation. This is actually bad overall because everyone puts off buying something expecting the price to be lower later … why not buy it when it is cheaper? But … this means everyone is delaying buying and the economy slows down. Businesses aren’t selling as much as before so employees get laid off. Now, they have less money than before, combined with higher unemployment, and the economy stalls. Deflation happened last in 2008 – fortunately is was short lived.

Naturally, technology helps keep prices down. Consider TV prices historically. Therefore, general prices in the economy overall is a combination of items with rising prices and items with decreasing prices. An individual’s inflation rate may be different than the economy overall because the individual’s mix of goods and services would be specific to them.

Finally, how much something costs is also in relation to how much they make. Household income also changes over the years. If your income is up, naturally you can buy more; and vice versa.

I’ve linked to some historical data above so you can get a perspective on how things change over time.

Moral of the story: while debate in the media may be about many of the above issues and concepts – it really only matters when prices are affected for those items you need. That is complicated a bit because what you need slowly changes over time as you age. Trying to plan out what you are going to buy and budget for each of those future years accordingly is a futile exercise in my humble opinion. More important is to evaluate how much you need to have now, in total overall, that will generate a total amount of money for your needs each year. How you spend that total amount of money year by year in the future, will change.

We don’t know what those future purchases will be today. Will you still live where you are now? Will utilities be the same as they are now? Will you eat differently than you do now? How have these changed over the last 10, 15, or 20 years? Next year will likely be similar – but with subtle changes. The year after that, subtly more different, etc., etc. When you really think about it – how much of your expenses are really “fixed” and don’t change? Most people are surprised that only a small percentage of their expenses are really fixed (e.g., a mortgage); and even those may change if you decide to make a change you hadn’t planned on earlier.

Therefore, the most important part of your plan is to have enough resources overall – how you spend it each year is freely up to you. Worry about those things you can control and not about what you can’t.

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