What is inflation and how does it work?

The inspiration for this article occurred because I saw how Big Mac burgers from McDonald’s are more expensive than ever, thanks to inflation. Now, I haven’t had a Big Mac since high school. However, I was pissed off when I realized it currently costs on average around $6.05 compared to $1.60 in 1986!  

Now that I am an adult, I realize how crazy it is that I never fully learned about inflation and how it affects my daily purchases. The American dollar dropping in value can impact the cost of gas, groceries, houses, etc. 

Today, I want to focus on helping you better understand what inflation is and how it works. Most importantly, how it affects you and some strategies you can utilize to keep more money in your pocket! 

What does inflation mean without using fancy financial jargon and terminology? Essentially, inflation is the decline of the dollar’s value. For example, you were planning to travel to Japan, so you wanted to know the dollar exchange from American money to Japanese yen.

If we were going through an inflation period, that American $1 you want to convert into yen may go like this:

American $1 to Japanese $1

To receive $1 in yen = $1.10 in American currency if America was experiencing inflation. 

Compared to deflation, which is the opposite of inflation. Deflation means that the dollar’s value would increase and be worth more to citizens of that country. This would decrease the price of products and services since your dollar is worth more.

Inflation is considered the worst form of tax because if you were given a raise at work by 2%. But, inflation was running at 5% across the country; well, you just lost out on 3% with your salary for that year…In the example above, you notice that inflation causes things to become more expensive. So, that gallon of milk which used to be $3.15, would now be $4.00. 

Unfortunately, when our country enters into an inflation period, you may notice that the economy has slowed down significantly, and people cannot make the purchases they once did. You might even be thinking, hey, I think we are in that time right now?! Yes, you would be correct in that statement.

Due to Covid-19 happening in 2020, America shut down for over 6 weeks, and the world came to a screeching halt. No one was dining out, going to hair salons, eating popcorn at the movie theaters. Everyone tried their best to stay home and lock up their money until they knew what would happen next.

Once stimulus checks were sent out, you finally saw the world begin to come back online again and continue with engines running, full speed ahead. This caused inflation to start to creep up further on America. In February 2022, America’s inflation rate had surpassed 7%, which is very concerning since the Fed likes to keep us around 2% for inflation rates. 

This is the highest inflation rate since 1982. Due to the unfortunate effects of Covid, America is experiencing an abnormal amount of inflation from the low supply of items and the high demand for those same items. There are 3 ways inflation can occur, which I will detail later.

Generally, the government or central bank is responsible for controlling and dispersing inflation in the country. One of the main ways to combat inflation is to tighten up the money circulating around the country. This forces people to stop spending because they cannot easily access as much money. From that cause, the effect is that the dollar’s value increases because not as many people have access to it. Since America’s government can print as much money as they would like, it decreases the value of the dollar bill. Hence, the printing needs to be cut back to force the bill’s weight back up.

Now, let’s dive into the 3 ways that inflation can occur:

1. Demand-pull. This is what we experienced from Covid-19. When the demand for goods and services is too high, the sellers cannot produce enough to meet the demands. It gives the sellers more power because they are now in a position where more people need what they currently have in inventory. So, what happens? They can increase the price of their current products. For example, you only have 100 hats, but 2000 people have put in an order for your hats. You can decide to change the sale price from $20 to $50 since you know people want what you have and are willing to pay extra.
2. Cost-push. When the materials needed to make a good/service increase, it forces the company to increase the customer price. An example would be if the fabric company making your favorite hat cannot afford the new price for the same fabric they have been using. The hat company will have to increase the price of the hats to make up for the high cost of fabric material. A foot of fabric may have only cost the company $5, but now it is $10. So the hat company changes the cost of the hats from $10 to $20. 
3. Built-in. To compensate for the constant change in prices, the built-in concept means that wages will rise to match the cost of living. This is why you can see the evolution of minimum wage increases over time (not necessarily in tune with the cost of living, but you get the idea). Also, you can learn more about the Consumer Price Index, CPI. The CPI is how the government can calculate the cost of living prices, just an FYI. 

A question you might be thinking about is how does the government even calculate the inflation rate? How do you turn it into a quantifiable number that everyone can essentially understand? I’ll tell you! The inflation calculators, which you can find online, were created by intelligent people who are way smarter than me in the math and economics departments. The formula you would use when trying to understand the inflation rate of something is below.

Percent inflation rate = (final CPI value/initial CPI value) x 100

https://www.bls.gov/data/inflation_calculator.htm

The link above will calculate the inflation rate you are looking for. For example, if you type in $10,000 and insert the time frame from Jan. 1972 to Jan. 2022. The calculator will show you that you would need $68,500 in 2022 to equal $10,000 from 1972. You can get an excellent idea of how much power the American dollar has lost over time. 

How does inflation impact you directly? If you have made it this far in the article, I am sure you have a reasonably good understanding. However, allow me to really rip the carpet out from under you. The weaker the dollar becomes, the more money you have to spend on that exact same item. 

If you had a 10% return from stocks you invested in, with inflation hovering around 5%, your actual net and return from the invested stocks is only 5%. How about a house for you? Homes increasing is a sign that there are not enough houses to fulfill the market, so home sellers can charge you more for the house. Or the construction companies have to pay more money for expensive products, meaning you have to pay for a higher-priced home. What about businesses that you make regular purchases from? During times of inflation, they are being charged a higher cost of labor. As the customer, you will have to pay a higher price or a higher monthly subscription (cough cough NETFLIX).

Don’t worry though, I have good news, there are strategies you can implement during times of inflation!

• Experts recommendation. Look at mutual funds/ETFs and stocks that perform well during inflation. Industries like oil, energy, commodities (steel, chemical, metal), and aerospace or heavy machinery, to name a few. Also, since we live in the tech era and technology is here to stay, tech mutual funds/ETFs can be beneficial. Always talk and meet with an expert before embarking on any investment. 

• Keep your ears and eyes open! Suppose you see the Federal Reserve making headlines for not purchasing bonds (pausing any spending on bonds) or raising interest rates. In that case, this could indicate inflation increasing over the standard 2%. 

• Re-evaluate short-term & long-term plans. This strategy will be important for those who witnessed the housing market skyrocket and prices become a bit outlandish in 2021. If you are seeing housing prices rise, run the numbers and consider if now is the best time to upgrade to a new or bigger home. Potentially think about saving money during the high price time and waiting for the market to cool down before moving (the housing market is constantly fluctuating up and down). 

• Budgeting. Establishing a budget and spending limit can help give you a cushion if the worst has yet to come during inflation. There are hundreds of strategies, but here are some quick and easy ones you can try implementing. Carpool with a friend or co-worker to work (if you do not work remotely). This saves money on gas and car expenses. Consider trading in your model for a more fuel-efficient model for those who drive. Work to cut out 1 day of eating out during the week and try making more meals at home. Use the popular site Groupon to receive deals and discounts for thousands of activities and events you want to attend. Also, consider an account that grows your savings with a higher interest rate than the standard savings account at a bank. Bankrate says the national average interest accumulated in a savings account is only around 0.06%. Various accounts allow you to keep your lump sum of money in an account that includes a much higher interest accrual rate (some starting at 0.50%). Meet with an expert if you are interested in learning more! 

$1000 x 0.06 = $60.00 (a year in a regular savings account from a bank)

$1000 x 0.5 = $500.00 (a year in a various accounts to grow your lump sum)

A few other strategies you may see people utilizing are buying gold, commodities, and sometimes even real estate because they are trying to hold tangible items. Generally, people will transfer their cash into more solid items with weight and higher value during inflation. The Fed’s long-term goal is to get the country back on track by enforcing price stability. This involves getting as many qualified people as possible to become employed and maintain moderate long-term interest rates for citizens.

This concludes today’s article, and I hope that it was helpful to you and got you thinking more about financial literacy. I always want to hear your thoughts and questions, especially about finances. Please email me your questions and leave comments below because I want to know what you think. Check out the website to keep reading more!

And remember, like Earl Nightingale said, “Everything begins with an idea.” See you again next time!