What is inflation?

Inflation refers to the general increase in the price level of goods and services in an economy over a period of time. When inflation occurs, each unit of currency (such as a dollar or euro) buys fewer goods and services than it did previously. In other words, your money’s purchasing power decreases as prices rise.

You may have observed that as you age, you’ll notice that the cost of living tends to rise. For instance, if we look back 20 years ago, purchasing a house was considerably more affordable compared to today. Over time, virtually everything becomes pricier, and this phenomenon can be attributed to inflation.

Inflation is typically measured using various price indices, with the Consumer Price Index (CPI) and the Producer Price Index (PPI) being commonly used in many countries. These indices track changes in the prices of a basket of goods and services over time.

You can check this link for US CPI.

In the United States and Canada, the usual inflation rate is approximately 2%, which is the targeted level set by the government. They aim to maintain this 2% inflation rate through a combination of monetary and fiscal policy measures, a strategy often referred to as “target inflation.”

Inflation is beneficial for maintaining a stable economy, which is why governments establish annual target inflation rates.

The issue with inflation is that if you don’t spend your money promptly, its value diminishes over time. This happens because prices tend to increase by about 2% each year, assuming inflation remains at that level, though it could potentially be even higher. In essence, your money loses its purchasing power.

Imagine you have $10,000 at this moment, and with that sum, you can purchase a substantial amount of goods and services. However, if you were to stow it away for 10 or 15 years and then decide to use it, you would find that this $10,000 wouldn’t have the same purchasing power as it did initially. Over time, the cost of everything would have risen significantly.

Due to inflation, it’s not advisable to hoard your money in cash, as it steadily loses its buying power over time. Consequently, cash ranks as the least favorable long-term investment option. While cash is an excellent choice for short-term needs due to its stability and immediate liquidity, it performs poorly as a long-term investment.

Many individuals may not grasp this concept because cash doesn’t experience as much volatility. For instance, if you hold onto cash, it may gradually lose 2% of its value each year. On the other hand, when you consider stocks, they can plummet by 50% within a year if a market crash occurs. This is why people perceive stocks and other financial instruments as risky; they have the potential for significant short-term losses. However, when you examine stocks over a more extended period, historically, they have generally shown positive growth. In contrast, if you evaluate cash over the long term, it consistently loses value.

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If you anticipate needing funds within the next year or a few years, it’s wise to have cash on hand to avoid the fluctuations associated with stocks. However, if your intention is to retain money for a period as long as 20 years, it’s not advisable to keep it in cash. Instead, you should consider investing it in assets that have the potential to appreciate in value and preserve your purchasing power over time.

Due to the impact of inflation, there are two key actions we should take. Firstly, we should place our money in an investment that outperforms inflation, ensuring that we gain more from the investment than we lose to inflation. This approach helps us preserve our purchasing power. Secondly, we aim not only to preserve our purchasing power but also to enhance it by surpassing inflation. In other words, we strive to earn more than the rate of inflation so that our wealth grows over time and enables us to afford more.

You must, at a minimum, increase your income by the rate of inflation each year. Failure to do so means that you are effectively experiencing a decrease in your real income each year, as you are earning the same wage while the cost of living rises.

In extreme cases, inflation can become hyperinflation, where prices skyrocket uncontrollably. This can have devastating economic and social consequences, as it erodes the value of money so rapidly that people may lose confidence in the currency.

What is disinflation?

Disinflation refers to a situation in which the rate of inflation (the increase in the general price level) is decreasing.

In other words, prices are still rising, but at a slower rate than before. Disinflation means that the economy is experiencing lower inflation than in the past, but it doesn’t necessarily indicate a decrease in prices or a negative inflation rate.

It’s a milder form of inflation that might be considered more manageable by central banks and policymakers.

What is deflation?

Deflation, on the other hand, is a situation in which there is a sustained decrease in the general price level within an economy.

This means that prices are falling, and it is often accompanied by a decrease in consumer spending and economic activity.

Deflation can be problematic for an economy because it can lead to a downward spiral where falling prices lead to reduced consumer spending, which in turn causes businesses to cut production and jobs, further depressing demand and prices.