NOTE: This article is a bit more technical than usual, but I hope you’ll take the time to read through it. I think it will be helpful when making your monthly budget!
If you read the news, you’ve probably encountered articles about the economy. Journalists and news anchors give measurements and numbers that are supposed to help us understand our economy’s health. But when terms like “inflation” and “deflation” are thrown around, sometimes we get confused about their meaning. Either we assume we know what they mean, or we ignore them because we figure someone else can worry about that.
But since everyone is affected by the economy, I think it makes sense that everyone should pay attention and know what’s going on. Understanding the terms empowers you to take confident action, rather than fretting endlessly over things you can’t control. If you want a better handle on your finances, you’ve got to start with a little financial education. Let’s start by talking about inflation.
Doesn’t Inflation Mean Prices Went Up?
Sort of. Nowadays, when people use the term “inflation”, they are generally using it to refer to an increase in prices (often called price inflation). But the term was originally used to refer to an increase in the amount of currency in circulation (often called monetary inflation). Many dictionaries have changed their definitions of inflation over the years to match current usage, but I think it’s important to understand the origination of the term. When I use the term “inflation”, I’m referring to an increase in the currency supply because it’s the cause, not the effect.
The major effect of the increase in currency is that prices go up. This is why the term “inflation” has shifted to mean “price inflation.” That’s the part that the everyday consumer sees and feels. The currency supply gets diluted by additional currency units that are added, so each dollar ends up buying you fewer things. This is because the law of supply and demand applies to currencies as well — when there is too much supply, demand goes down. And when demand goes down, the price goes down. I know we don’t often think of the dollar as having a price, but it does. If you travel to another country and you have to exchange currencies, you’ll discover what that price is when measured in another currency.
What About the CPI? Doesn’t that Measure Inflation?
The CPI is another term that gets used in reports about the economy. It stands for Consumer Price Index, and it is a measure of changes in the prices of selected products. That means that the cost of certain everyday items is tracked, and over time, the average increase of those prices is reported as the CPI.
So when you hear that the CPI is 4%, that means that everyday products have risen by an average of 4%. However, just like with the term inflation, I think it’s important to know some of the background and history behind the CPI.
In the United States, the CPI was originally calculated by comparing the price of a fixed basket of goods from two different time periods. So the CPI was strictly a cost of goods index. However, at some point, Congress decided that CPI should be used to measure changes in costs required to maintain a constant standard of living. This changes the CPI from a cost of goods index (COGI), to a cost of living index (COLI).
The difference is important, because a COGI is concrete and specific. A COLI, on the other hand, is more subjective, because interpretations vary on how to define the standard of living. With the ideological shift from COGI to COLI, Congress has also made changes to the methodology used for calculating the CPI. These changes allow for substituting goods in the basket, which tends to result in a lower CPI.
Have you ever felt like prices were rising faster than they used to? That even with your job’s cost of living increase, you still have to cut back on what you buy? The CPI says there was only 2% price inflation over last year, so it must be your imagination, right? It could be that you are expecting a COGI number (which would be higher), rather than the COLI number that is being reported.
Why Should I Care About Inflation?
Two words: “Purchasing Power.” Inflation erodes the purchasing power of the dollar. So each year, a $20 bill will buy you less and less stuff. At one time, $20 was enough for two people to go out for dinner and a movie. Not anymore. I remember when $20 would fill up my tank with gas. Not anymore. Right now $20 will buy you a new DVD. Will that be true next year, or the year after?
You should care about inflation because you want to keep as much of what you earn as possible. That means you have to adjust your budget accordingly. Monetary inflation is off the charts at this point, so you either need to figure out how to increase your income, or spend less to compensate. But if you’re like many people, your income isn’t changing, and you aren’t changing your spending habits. That means you probably aren’t saving as much as you want to. And that can be a problem down the road.
What Can I Do About Inflation?
To overcome the effects of inflation, you need to make some changes. Given the choice between spending less and making more money, most people would choose to make more (I know I would). So how can we do that? How do we increase our monthly income?
While it’s good to be well-rounded, you can’t know everything. I would say that this is a situation where you should look to someone who is an expert in this area. You are an expert at your job, whether you fix cars, make sales, or write computer code. But there are others who excel at growing and protecting wealth. Why not get some advice from them?
Let me be clear: not all financial advisors (or services) are created equal. Before taking someone’s advice, you should do your homework to make sure they have a good track record, and lots of positive testimonials. We’re talking about the money you’ve worked hard to earn, so I wouldn’t trust just anyone when it comes to how to use it.
Many online financial research firms have a free version of their newsletter/publication. I recommend you try a couple and see which one(s) provides the best advice. These newsletters will give you tips on generating additional income, investing, and beating inflation. And if you really like the free newsletters, you can always upgrade to a reasonably priced paid subscription (assuming the newsletter is helping you earn enough extra income to cover the cost).
If you decide to hire a personal financial advisor, ask them about what type of recommendations they usually make. You want to find an advisor whose advice is not limited to the stock market. A good financial advisor will help you diversify beyond the stock market, by looking into other asset classes such as commodities and real estate. Ask the advisor if they use the strategies they recommend with their own money. If so, that’s usually a good sign.
The point is that you need to do something. Thanks to inflation, doing nothing means you are actually losing money over time. But now that you are aware of how inflation can erode your savings and your purchasing power, it’s up to you to take charge and of the situation. Make an educated decision about how to protect your money from inflation. Start by signing up for one of the newsletters above to continue your financial education, and you’ll be glad you took that first step. You’ve got to start somewhere!