Inflation comes from the latin "inflationem" meaning a puffing up or blowing into. Or flatulence, lol! https://www.etymonline.com/word/inflation

It’s one of the things that can blow up your budget and the economy over time if unchecked.

How does it relate to money? Inflation is actually one of the lease estimated “costs” in a person’s lifetime.

First of all, what is it really?

 

A typewriter and a piece of paper reading "inflation"

 

Inflation is measured nowadays by the Consumer Price Index, CPI. The CPI looks at a common shopping "basket" of goods for consumers ranging from groceries, gas & transportation, consumer electronics and entertainment each year.

Essentially the CPI tells us how much more expensive it is this year to buy the same things compared to last year.

That’s inflation.

The cost of goods tends to rise as more people want the goods, and as the dollars used to buy those goods are continually printed or minted to pay for them.

Think of it this way… when our parents were growing up, candy bars used to cost $0.50. Now, they are over $1.25! What gives? Well, there are several factors at play including the retailer, the banks, and the federal reserve.

Where does inflation come from?

When there are more dollars produced or available to purchase goods, the costs of the goods tends to rise. Most companies want to show a profit. If they raise their prices, then some of the companies they supply may want to raise their prices as well.

 

It's sort of a chicken or the egg problem. If I'm a business that borrows money to produce my goods my profit will be sensitive to interest rates. If my business used to borrow at 4% and now rates are 5%, I may charge 1% more to buy my goods.

 

Because I want to keep buying all the stuff I'm used to too!

 

So, if banks raise rates, businesses may charge each other more, and that gets passed to consumers. So, what do consumers do? They seek out pay raises or new employment to keep up their standard of living. Now companies are paying more for their workers, and probably have to raise prices again soon.

 

It's a cycle.

 

Does it start with banks? Well, kind of… If interest rates are low, businesses and consumers will borrow money to use for endeavors they enjoy or want to grow their net worth with. But the only way banks can lend money is if they have (some) money from depositors.

 

Well, if interest rates are so low, why would I save my money at the bank?

 

So the federal reserve eases interest rates up to encourage saving. As rates rise the lending may slow, because businesses don't want to pay a ton to borrow money.

 

As lending slows, then banks feel less inclined to pay out interest to depositors, because they may no be getting enough loans to cover the float, or the profit of the interest of the loans.

 

So, they work with the fed to lower rates.Photo of a circular cycle

 

It's a cycle.

 

What does inflation mean for you?

 

The long term average rate of inflation is about 3.2%

 

So if your income isn't rising by 3.2% each year (on average), then you could be feeling the pinch of rising prices.

 

The rule of 72 is a neat way to estimate how long it takes for your money to double if invested. You take 72 divided by the interest rate, and the answer is about how many years it will take for your money to grow to 2X it's size without any additional investments.

 

For example, $10,000 invested at 8%

72/8 = 9

9 years for your money to grow to about $20,000

 

This rule works for inflation too. 72/3 = 24

Every 24 years things double in the price.

 

Your investments and savings need to get about 4% to at least keep your standard of living!

 

This is a big deal because the longer you wait to start saving, the more that inflation will "cost" you in the long run!

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