Inflation and Your Money

Imagine going to a restaurant to buy a cup of coffee and being told that the price was $5,000. After ordering a second cup, you request a bill and see that the total cost for two cups of coffee was $14,000.

Upon enquiring about the obvious error you were told, “If you want to save money and you want two cups of coffee, you should order them both at the same time.”

You may think that this is just an amusing story. In fact, this was a real-life example of life in Germany after World War I recounted in Adam Smith’s Paper Money, which described the extreme effects of inflation on that country’s economy.

What Is Inflation?

Investopedia.com defines inflation as a “sustained increase in the general level of prices for goods and services, which is measured as an annual percentage increase”. Simply put, inflation will cause you to spend more money on the goods and services you normally buy. Therefore, a fixed amount of money (such as your salary) will buy progressively less things as inflation increases.

The two key points to note about inflation are that:

1. The prices of goods and services are going up
2. The value of your money is going down

If you can envision a graph of these two effects of inflation, you will realise that the cost of living is going in one direction - up, while your spending power is going in the opposite way - down. No wonder so many of us feel distressed after a trip to the supermarket!

Jamaica’s inflation figures at the end of December 2008 showed a 16.8 per cent increase in prices over the previous year. This means on average, an item that cost $100 in December 2007 would cost $116.80 one year later. The Bank of Jamaica calculates the inflation rate by periodically tracking the changes in costs of a large basket of basic goods and services including bread, agricultural produce, clothing and electricity.

But what causes these costs to increase in the first place? Why can’t prices just stay constant over the years?

Experts who study money and economics agree that two main things will result in inflation:

1. When the demand for goods and services exceeds their supply, then prices will increase. This typically happens when there is too much money chasing too few goods.

2. When companies experience increased input costs such as salaries and raw materials, they will increase their prices to maintain their profit levels.

What Are The Effects Of Inflation?

Although inflation may have caused us distress over the years, it would actually be bad for the economy if prices didn’t go up at all. The problem arises when the level of the increase is unplanned and unexpected.

Some of the adverse effects of higher-than-anticipated inflation are:

. people who receive a fixed income, such as retirees, will not be able to maintain their standard of living and may not even be able to afford to buy basic necessities;

. if the savings interest rate is less than the inflation rate, then you will experience a negative return on your investment and you will lose money;

. businesses will try to cut costs as they may not be able to pass on all increases to the customers, so employees may lose key benefits and even their jobs;

. general uncertainty about the economy will curb the spending habits of both individuals and companies, which will slow down growth and development.

What Can You Do About Inflation?

While you may not be able to prevent high inflation from occurring, you can implement measures to mitigate its effects on your money:

1. Put aside some of your income - don’t spend it all. Even if it’s difficult to save ten per cent of your earnings, start by contributing a fixed amount every month. This will help you to build a money foundation that can protect you in challenging times.

2. Turn your savings into investments. Investing occurs when you put your money to work with the expectation of making a profit. Some investment options are the money market, bonds, stocks, commodities, real estate and even your own business.

3. Choose investments that can stay ahead of inflation. With the assistance of an investment advisor, you can select a portfolio of assets that have traditionally outpaced inflation. Consider long-term assets such as real estate that will retain value over time.

4. Increase your investments with inflation. Some investment options will automatically increase your contributions in line with inflation. This will allow you to build a realistic nest egg for long-term goals such as retirement.

5. Boost your earning power. Don’t be satisfied with one income source, look for multiple ways to generate extra money. This will help you to maintain your spending power even when prices are increasing.

Copyright © 2009 Cherryl Hanson Simpson