The simplest definition of inflation is the decrease in the purchasing strength of a given amount of money over a specific period of time. Most working people know the real-world effects of inflation because they notice higher prices when shopping for groceries, fuel, professional services, homes, and more. In nearly every instance, inflation results from prices rising faster than average wages.
For economists, it’s easy to measure inflationary changes in terms of specific percentage increases in the cost of a particular basket of common goods, like a typical week’s groceries for a family of four. On news and financial TV shows, you’ll hear about the standard cost of a market basket, with commentators pointing out whether the price has risen or fallen during the past week, month, or year. Unfortunately, even modest price increases have the potential to erode your savings, buying power, and net worth as time passes.
In addition to retail goods, other segments of the economy are deeply affected by inflationary pressure. Inflated prices throughout an economy mean weaker currency values, poor performance of retirement savings accounts, lower buying power for your income, and other negative repercussions. Here are several of the most typical results of inflation.
Inflation’s effects are most apparent in the market for retail goods. All you need to do is walk through the aisles of a grocery or clothing store at one-month intervals and make note of price changes. For family’s rising prices take their most significant toll at the grocery store, fuel pump, and restaurants. While it’s possible to avoid dining out, it’s tougher to cut down on the amount of food you eat at home or the volume of fuel you purchase for necessary travel.
As an example of inflation’s role in currency strength, here’s a hypothetical case. Assume the United States economy’s current inflationary rate is 10 percent and the rate in the United Kingdom is two percent. If all other major economic factors are equal, the UK’s currency will be stronger than the dollar. Investors use logic when they assess currency values in the forex markets on a day-to-day basis. They tend to prefer currencies that are more stable and are able to hold their value. Forex traders usually study multiple factors before deciding which currency pair to buy and whether to go long or short. While inflationary economies tend to be weaker than non-inflationary ones, forex markets factor in the relative rates. Of course, other things, like balance of trade deficits, political instability, and unemployment rates, are also important.
If you have a retirement account, it’s possible to see your long-term wealth suffer as a result of rising price levels. Say your nest egg is part of a fund that earns six percent interest per year. If inflation’s bite out of that growth is five percent, then you’re only making one percent per year on those retirement dollars. It’s essential to calculate price level changes when figuring the real rate of return on retirement accounts.
In general, inflation tends to drive up the demand for gold, which nearly always sends gold’s value higher. That’s one reason so many people flock to gold and other precious metals as a safe haven form of investment when the price of retail and other goods begins to rise.