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Home » Inflation, Personal Finance Planning

Inflation: How to Beat it with Smart Financial Planning

Last updated by on 13 Comments

How to Outpace Inflation

This is a guest post from Shaun Connell, author of Learn Financial Planning, a series of free, comprehensive financial planning tutorials.

It’s hard to watch the news or keep up with anything financial without hearing about inflation, deflation and our current money supply. Understanding inflation is essential to the basics of personal finance. It’s not just an economic concept it impacts you every day, and is only of the biggest obstacles your investments will face.

Inflation is when your dollar loses it’s buying power. Inflation is when is takes more currency to buy the same amount of stuff.

Take penny candy, for example. I still remember when I could buy a small piece of candy for a penny. Now, I haven’t seen penny candy in years. This doesn’t mean the candy disappeared. No, you can still buy the candy I used to buy… now it just costs ten cents or more. This means one of two things:

  1. Candy is becoming more valuable, OR
  2. Our currency is becoming less valuable

inflationThe second is, by far, the most important concept to understand. That’s because the price of almost everything has gone up over the past few decades. Overall, our money is becoming worth less and less. The penny isn’t what it used to be.

But why? What does this mean for us?

What Causes Inflation?

One of the most basic principles of economics is how the law of supply and demand affects prices. If there’s a bunch of something, it’s usually not valuable. If there’s not much of something, it’s usually pretty valuable. To simplify the concept: the more that’s available, the less it’s worth.

For example, a truckload of gold is worth more than a truckload of sand. It’s all about what economists call “scarcity.”

Remember, our money isn’t inherently worth anything. It only has worth because people think it does, and because it’s relatively scarce. There aren’t millions of dollars under every bed. Money simply represents the real material wealth that others own. If there’s more paper and less wealth, then the ratio of dollars to value goes down, the dollars are worthless.

So what causes inflation? Though there are an incredible number of complicated smaller causes, the biggest cause is simple: the government decides to print more money. The actual material wealth in the economy isn’t changing. The government doesn’t make money; the government just prints money.

Inflation is what happens when there’s more “money” being created than there is worth being added. In other words, if the government prints 100 trillion new dollars, and our real GDP only grows about 10 trillion dollars, we’ll be seeing roughly 90 trillion dollars diluting the value of other dollars. That’s inflation.

But why should we care about inflation?

How Inflation Hurts You

Inflation slowly erodes the value of your wealth. The average yearly inflation is about 3.43%. This means that every single year, the cash you have is worth 3.43% less. That might not sound like much, but it’s simply mindboggling:

  • Fact: Investments really make less than you think. If you make an average of 6% return in your investments every year, you’re actually only making about 2.6% per year after factoring into account inflation.
  • Fact: Investment fees are eating into your returns. If you are paying anything more than $5 for your trades, you’re getting hammered.
  • Fact: For most people, a “raise” breaks even, maybe. If you get a 10% raise every three years, you aren’t actually getting a raise at all. You’re actually living on 3% and 6% less for two years preceding your raise after factoring into account inflation.

Inflation especially affects the people in the lower income rungs. Right now you can’t get away from hearing about inflation and deflation — it’s all over the news. Why? And what should you do?

What is Deflation?

Right now, we’re actually seeing a major amount of deflation, caused by the recession and low oil prices. This means that your money actually has a bit more buying power than usual.

But don’t get comfortable. We’re about to see record levels of inflation in the next few months and/or years. Just consider the following facts:

  • Fact: More Fed loans are given, increasing inflation. All over the news, you can see reports that the Federal Reserve is lowering interest rates down to nearly 0%. This means the Federal Reserve (the people who print money) will be giving out more “loans.” A “loan” is when we give money that doesn’t yet exist for banks to loan out. The lower the interest rate, the more loans are given out, the more money is printed.
  • Fact: We’re already printing a lot, increasing inflation. In the past few months, the Federal Reserve has already printed more money than the last 19 years combined.
  • Fact: Spending increases printing, increasing inflation. Over the past few months, Bush has spent over a trillion dollars to help the economy. Obama has already pledged at least another trillion towards his economic stimulus alone. Spending several trillion dollars is a surefire way of increasing inflation.

I’m not saying the world is going to end — just that inflation is going to start again, and soon. We’re seeing deflation right now, which means one thing: This is the perfect time to get prepared.

How to Beat the Future Inflation

Understanding inflation isn’t enough; you have to be willing to take actions to “beat” inflation. Though there are many tactics, the four tips below are simply a must for a rational financial plan:

  • Stock Up. Remember, as we’ve talked about before, we’re currently in the middle of deflation. That means that items that will be increasing in costs in just a few months to a year are actually much, much cheaper. So stock up. Buy bigger boxes and value packs. This is usually still a good idea, but right now it makes even more sense.
  • Precious Metals. Usually, I’m not a big fan of precious metals like gold and silver, and encourage their purchase only for the sake of diversity and financial security. But due to the recession, the price of gold looks good. Precious metals are also a great “crisis hedge” in the sense that during times of crisis, investors often flee back to precious metals.
  • Save, Save, Save. As mentioned before, a high-interest savings account will allow you to just break even. But right now, with deflation, you’ll actually be making even more. Remember, deflation is the opposite of inflation, which means for every 1% of deflation, your money’s value increases about 1%. This means that you should be storing your money away while in deflation periods for two reasons:
  1. To have extra money on hand when prices increase, and
  2. To make an extra couple of percentage points due to the deflation.
  • Get That Raise. Though this might be considered a “duh” point, it’s important to understand. Inflation means you’re getting a built in pay cut of at least 3% every year. In the next few years, that’s going to get worse… a lot worse. This means that now, more than ever before, is the time to focus on working harder and doing things that will get you noticed. At this point, getting a raise is often still just a defensive measure.

Inflation Conclusion

Remember, the laws of economics don’t change just because we’re having a financially rough time. If anything, this is the time we should focus on the economic and financial principles that get us to prosperity.

This means you don’t have to do anything “special” to combat inflation: just do what you already know you should do. Extraordinary financial times call for extra ordinary financial measures.

Inflation Discussion:

How is inflation impacting your long-term savings plans?

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About the Author
I am G.E. Miller, & this is my story. My goal is financial independence ASAP. If you share that goal, join me & 7,500+ others by getting FREE email updates. You'll also find every post by category & every post in order.


13 Comments »
  • Will says:

    Very useful information, simple, straightforward, and effective.

    It’s simply ridiculous that we refuse to learn the lessons of history and abandon sound monetary policy for short term economic needs. Didn’t the Reagan/Volcker measures of the 1980s teach us anything?

    I appreciate the advice on hedging your portfolio against inflation. I’ll have to keep that in mind.

  • Craig says:

    Good basic article about what inflation is and how it can affect us. Simple question, but why would the government print more money full well knowing it is going to increase inflation?

    Investing now is something I would like to do but not sure if I have the funds or knowledge to do so.

  • Shaun Connell says:

    Great question. I honestly wish I knew. Fed Chairman Ben Bernanke once said that whenever we see “deflation” his response is going to be, literally, the “printing press.” His words, not mine. So this period of deflation isn’t going to last long by design.

  • K burbut says:

    @Craig and Shaun: Deflation is not good because it lessens consumption: If you know that f. ex. your car, now worth 20 000 bucks will be worth e.g. 19 000 bucks in six months due to deflation, would you buy it now? Or wait? This covers all articles in one’s economy. Therefore deflation should be fought, as well as excessive inflation. Small inflation is good as it encourages economy, too high, on the other hand is devastating.
    Cheers.

    K Burbut

  • Laura says:

    Excellent article, thank you for the information!
    You are very well organized, and broke down the concept so it was easy to understand. I hope to read more from you in the future!

  • stephanie says:

    Excellent analysis. Nothing I didn’t already know, but a good reminder about how and why things work. It’s too bad more people in this country don’t understand basic Economics. My guess is that most people in government know the long-term consequences of their actions – but if they want to get elected (and re-elected), they have to provide short-term relief to the masses who don’t understand that real change can’t be achieved overnight.

  • Shaun Connell says:

    K burbut, I never really made the claim that it was bad that inflation is going to happen, only that it will. As the Financial Times reports, the Fed is certainly talking about making it explicit policy to create inflation: http://www.ft.com/cms/s/0/1d472830-dc5a-11dd-b07e-000077b07658.html

    Inflation is just where our currency shifts around a bit. The wealth is static, but the numbers change. Making the right moves now can mean we gain quite a bit.

  • K Burbut says:

    Hello Shaun, I am neither saying that it is bad inflation will happen. I was just saying why deflation is bad and why it should be fough with inflation. I read there is a danger of deflation appearing in US.
    Best regards.

  • Craig says:

    @k burbut Thanks for clarifying, although with your example, a car worth 20K now may naturally be worth only 19K because it is older, even if there is no deflation. But I do understand your point. Is there a desired % you would like or ultimately you would hope for zero inflation or deflation.

  • Shaun Connell says:

    K Burbut,
    Deflation and inflation both cause problems with groups of individuals in the economy, so I certainly agree with you there. As far as to which one is preferable, I honestly couldn’t tell you, given that it’s hard to analyze a relatively small amount of inflation in a vacuum. The overall impact depends on the other policies and variables taking place.

    That said, if your car is worth less dollars, remember — your dollars can buy more. The overall impact to someone who has a job is actually good. But again, that’s analyzing an economic issue through the lens of a single individual who still has a job — many variables are being presupposed. Economics, of course, get messy. :)

  • ümraniye halı yıkama says:

    Good basic article about what inflation is and how it can affect us. Simple question, but why would the government print more money full well knowing it is going to increase inflation?

    Investing now is something I would like to do but not sure if I have the funds or knowledge to do so.

  • CPB says:

    I missed this article when it was published. I just saw it in the related post section of your latest article.
    This one is nice and especially helpful to those newbies in “personal finance”.
    I would admit that I don’t even considered inflation before.

  • Kyle says:

    I am glad folks like you are Richard Maybury fans (author of “Whatever Happened to Penny Candy”).

    Thanks for putting this article together. It is now April 2011… we are on the cusp of seeing inflation skyrocket and the “velocity of money” (rate at which money changes hands as folks try to get rid of something worthless (cash) for something of value (essentials)) accelerate at an out of control rate. (To understand “velocity” of money… think about the childhood game of “hot potato”… nobody wants to be stuck with the potato so they try to get rid of it as quickly as possible).

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