Inflation vs Deflation and Why It Matters

What is inflation, what is deflation and what benefits to knowing? We’ll explain the basics and what you need to know to make sure your money keeps pace.

Inflation and deflation are terms you hear thrown around a lot but what do they mean and what impact do they have on us?

What is Inflation?

The value of a dollar is determined by its purchasing power, the number of things or services which that money can buy. When inflation increases, the purchasing power or our dollar decreases.

In the US, our rate of inflation is 3% a year on average. That means the newspaper that costs $1 now will cost $1.03 the following year. Inflation means your dollar doesn’t go as far as it once did.

Types of Inflation

Demand-Pull Inflation: This is caused when there is an increased demand for something which drives up the price. When demand grows faster than supply, the price goes up.

Cost-Push Inflation:If the cost to produce a good increase, a company increases the price to maintain their profit margin.

Monetary Inflation: This happens when there is too much money in an economy. Too much of anything makes the value or price go down.

The Impact of Inflation

Inflation is not always a bad thing across the board. There are winners and losers when inflation happens.

If you owe money to a creditor, you win! The cost of your debt is reduced. You really make out if the rate of inflation is higher than the interest rate on your debt. Inflation hurts your savings. A dollar saved now is worth less in the future when you need to spend it.

If your raise at work is not more than 3%, it’s not really a raise because it doesn’t preserve the buying power of your dollars. If you are someone who lives on a fixed income that is not adjusted for inflation, your dollar is worth less too.

If inflation in one country is higher than that of trading partner countries, the goods of that country are more expensive than imported goods. That can impact domestic producers and in turn, their employees

How Inflation is Measured

Inflation is measured by a market basket. It’s an imaginary basket of goods whose prices are totaled up. The number is called a price index and the cost of the basket is compared over time.

This number is the price index, the cost of the basket today as a percentage of the cost of the same basket in the starting year. There are two price indexes used to measure inflation, consumer price index and producer price index.

Consumer price index measures the change in price for consumer goods and services from the consumer’s perspective.

Producer price index measures the average change of selling prices over time for companies that make goods and services, so changes in price from the seller’s perspective.

The Federal Reserve is tasked with controlling inflation. Uncontrolled inflation can cause a recession. If the growth rate of the GDP exceeds 2-3%, demand can drive up prices leading to demand-pull inflation.

The Fed slows growth by tightening the money supply, they allow less credit into the market. This makes it more expensive to borrow money which slows growth and demand and brings prices back down.

What You Need to Know

Year after year, inflation eats into the power of your dollar. You can buy less with that dollar. You have to protect your dollars by investing your money where it earns more than the average rate of inflation, 3%.

The average return of the stock market over time is 7% so you’re beating inflation. The average interest rate on a savings or checking account is less than 1%, less than inflation so you are losing money when you have it parked in one of those low yield accounts.

When inflation is high, interest rates go up so if you want to buy a house or a car or borrow money to start a business,

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