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What is Inflation? To really understand inflation, you need to know what money is and what we use it for. Money represents the value of hard work and producing things that other people want to use. The measurement of this production or hard work is done with units of money. If I spend $20 to buy a can opener, that $20 represents one hour of work serving food in a restaurant, for example. You can see this by looking at a job that pays an hourly wage and then taking that wage and buying things you don’t produce to get all the things you need to live. The backbone of this idea is the exchange and trade of goods, as it may not be possible to craft everything you need on your own.
The assumption people make is that $20 today is $20 tomorrow. In fact, it is not. The prices of things are constantly changing and the value that $20 can buy depends on when you use it and what you buy with it. Do you want proof ? Look at the price of food, gas, education, rent, utilities, and many household goods and services over time. Prices go up most of the time for most items and that $20 buys less and less every year. To see a radical comparison, in 1920 $20 bought you a suit, a belt, and a new pair of shoes. Today, that $20 only buys you one belt. Inflation occurs when prices rise and more money is needed to buy things of the same quantity and quality. Deflation is when the same money buys more things of the same quantity and quality. This has happened with technology, clothing, and internet shopping, for example.
Inflation is also defined as the rate at which prices increase and the rate at which the value of the dollar decreases. What can you do there? In the 1970s and 1980s, you received raises at work each year that were at least equal to the rate of inflation or the rate at which the value of the dollar fell. It allowed you to buy the same things for the same amount of work you were doing. For example, if you earned $20 an hour in 1970, you can buy 5 liters of milk for $20. The following year, the price of milk rose to $21, your salary would rise to $21, and you could buy the same amount of milk for an hour’s work. If you are an investor, you would deposit money in a bank account with an interest rate equal to or greater than inflation so that you can buy the same or more goods with the capital you have invested. If you were a landlord, you would increase your rent by 5% to counter the increase in your charges by 5% so that your rental property would generate the same amount of profit despite inflation.
What happens if you don’t get that increase or the investments don’t earn a return equal to inflation? The value of the work you do decreases in value or the amount of goods you can buy for your work decreases. The value of investment capital also decreases over time. If this trend continues for a long time, your job will not allow you to buy much and you will approach slavery. Once the capital decreases to the point that nothing can be purchased with it, it is called insolvency.
The solution is to find labor, investments or assets that would maintain their purchasing power despite inflation. For the work, it is a question of obtaining wages which would increase each year. For investments, the income return or growth rate must be greater than inflation. For assets, these would be physical, tangible things that would still be useful despite the value of the currency. These are assets that people always need: food, water, shelter, land, productive capacity (tools, equipment) and precious metals to use as currency.
How to know the effect of inflation on your purchasing power? You must compare the annual increase in your income or capital with the annual increase in the price of the things you need. The government publishes an average number called the Consumer Price Index (CPI) which is supposed to capture this for the average person. To know your personal impact, you need to calculate what your income and expenses are as they change over time, your preferences and your ability to generate income.
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