Financial planning for everyone

Inflation: What Is It And Why Does It Happen?

"Inflation is the overall or specific increase in the cost of goods or services."

Thank you, Mr. Dictionary.

Inflation is when your mom or dad complains about the prices they have to pay nowadays compared to what they paid when they were younger. "I remember when a roll of Poppins only cost 20 paise." "I used to buy Tur dal at Rs.14/Kg." "When did milk get so expensive?" My Great Grandfather used to get a salary of Rs. 5 per month!!

Inflation in India has been relatively high. It is 18% for the common man. I am not kidding. I am talking about the consumer price index. What comes in the news paper is the wholesale price index which is around 9%. Some countries have experienced inflation above 1000% in a single year. A detailed analysis of the cause of inflation is beyond the scope of this short article, but we can mention some things that tend to cause inflation.

Increases in government taxes and fees can lead to inflation (especially when businesses are taxed). When the cost of business goes up, product prices go up. When prices go up your income effectively goes down. Then you have to work harder or find a better job. Or hope that your employer will give you a raise, which then makes the business costs go up and so prices go up and so on.

Also when your personal income taxes, property taxes, sales taxes, auto registration fees, etc. increase, you are forced to live on less or hit the boss up for a raise.

If you get your raise (and several of your co-workers also are given raises) the cost of doing business has gone up. The business will then pass the extra costs on to their customers - inflation.

Inflation can also be caused by scarcity. If there are only a 10,000 Pokémon Card packs, Teacher’s day flowers, Watermelons or whatever the current demand is, and there are 1,00,000 people that want one, the price is going to go up. If the bird-flu disease causes farmers to cull a large portion of their flock and there is less chicken on the market, the price of chicken will go up.If interest rates go up, inflation can be the result. If it costs more to borrow money, the cost of doing business has gone up and so will product and service prices.

For the last 10 years inflation has been relatively high. Many people have taken on additional debt rather than curtail their spending. But people can only stand so much debt. Once you are maxed out on your ability to pay (you may never max out your credit limit as long as you keep paying on time), you will either have to reduce your lifestyle, beg for a raise or find a higher paying job.

For the most part, regular, steady inflation has little effect on our day-to-day living. Most people get a pay raise every year or every other year that either keeps pace with inflation or helps them move a bit ahead. But when you are looking at the long run and making long term plans, inflation can have a big impact.

Most people look at their present living standards and estimate how much they will need to accumulate to survive. They don’t even take a second look at inflation. India’s inflation rate is currently above 9%. There are no Fixed Deposits which give such high returns. This means that for ever year that your money is in the bank you are actually losing money!! Don’t believe me? Go to the Best Fixed Deposits page and have a look. Don’t forget to punch in the inflation rate!

So inflation eats away your savings on a daily basis.

What can you do to stop it? Truthfully nothing. It is out of your hands.

Sure you may have your home paid for and you won't have to buy expensive work clothes or pay for lunch every day, but your medical bills will go up as you get older and your insurance costs will increase. Also you may want to golf or travel more than you do now. You will have more time for hobbies; how will you pay for them?

The best way to beat inflation when planning for the future is to include it in your calculations. The biggest problem we see with a lot of long range financial planning, especially retirement planning, is that people forget to factor in the effect of inflation on their investments and savings.

A good financial planner will understand the effects of inflation and help you plan for them. But I suspect that some less-trained "planners" (who are probably more like salespeople in a financial planner suit) tend to "forget", ignore or don't understand in the first place the effects of inflation. Leaving it out of the plan makes the calculations easier and may even help them get more "sales" because you are not discouraged by the truth. And their "product" (investment) may not seem as inadequate as it may really be.

Another quick way to account for the effect of inflation is to subtract the inflation rate from any rate of interest you will be receiving on an investment. So if you are going to assume a 10% inflation rate and the assumed rate of return is 11%, do the projection with only a 1% rate of return. This will give you a more accurate picture of the value (not the amount) of the investment at its maturity!!!.

Some investments such as real estate and precious metals (gold, silver, etc.) actually benefit from inflation. This may make you want to truly "diversify" your portfolio into more types of assets, not just more types of stock.

Inflation does not have to be scary as long as you understand how it works and how it affects your future money values. Accounting for it in financial equations and projections can be done simply. But overlooking it or downplaying its effects can cause you to miss your financial goals by a wide margin.

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David Berky is president of Simple Joe, Inc. a marketing company that sells simple software under the brand name of Simple Joe. One of Simple Joe's best selling products is Simple Joe's Money Tools - a collection of 14 personal finance and investment calculators.

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