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Alvin Hall's blog
Alvin Hall's blog
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Inflation: Your Guide to Understanding and Coping

The first definition of inflation I ever heard was from a college professor and I still remember it. He said it was “too much money chasing too few products.” I remember thinking that succinct, memorable phrase did not define inflation; instead it talked about what caused inflation.

I’ve learned that inflation is much more complicated than my professor’s little phrase would suggest. However, it is a good place to start understanding inflation.

The prices we pay for goods (groceries and petrol, for example) and services (electricity, home repairs, meals at restaurants, etc.) always increase over time. Some go up because the price is essentially controlled, like oil. Others increase because the costs of materials and manpower involved in the production rise. And some increase because the demand increases, but the ability to increase supply is limited. So, price increases are a natural part of economic growth.

Generally, our earnings (including periodic pay raises) and/or the money we earn on our savings and investments rise enough so that we are able to continue acquiring the goods and services we need or want. In an ideal economic situation, our wages, savings, and investments increase at a faster rate than the costs of goods and services, enabling us to save, buy better things, and feel prosperous.

Inflation occurs when the costs of goods and services we use increase, but your earnings remain flat or decrease. In effect, the money you earn or have saved buys less of the goods and services you need and want. This is what experts refer to as a decrease in the buying power of your money.

Like many people, I am perhaps most keenly aware of inflation when I go grocery shopping. This is essentially my own version of the Consumer Price Index (CPI) that the government uses to measure inflation in the UK economy. Since I take the same amount of cash with me each time, all I have to do is look in my trolley to see how many fewer items I can buy today, for example, compared to the beginning of this year.

Evaluating my grocery shopping from a different point of view, I can calculate how much more it costs me to buy exactly the same items today compared to what it cost me at the beginning of the year.

From either perspective, it is disquieting to see the buying power of the money that I earn shrink because of rising prices, while at the same time my income is essentially stagnant and the interest I can earn on savings in the bank is extremely low. This is a definition of inflation at the consumer level.

One of government’s key economic roles is to stimulate economic growth and expansion, while at the same time controlling inflation. It’s a delicate balance—more of an art than a science, although economists and government officials may not want to admit this. By keeping interest rates low, for example, government hopes to encourage businesses to borrow money and expand, which in turn should lead to hiring new people and wage increases. However, it may not work out that way, as we have seen recently. Instead, there may be no increase in economic output (i.e., goods and services available) because demand doesn’t increase (i.e., people are become more cautious in their spending); but prices rise nonetheless. This is the definition of inflation at the government level.

Inflation leaves you and me with two choices when it comes to spending: 1) buy less; or 2) allocate more money. The latter choice becomes difficult when our earnings are stagnant or declining.

Surviving a period of inflation will be challenging. There is no doubt about that. But you can survive by making some smarter choices based on a clear self-knowledge.

Know your essential expenses and your discretionary expenses. Knowing these numbers is essential. It tells you the amount that keeps a warm, well-lit roof over your head, food on the table, clothes on your (and your family’s) back, and a means of getting to work so that you can continue to earn a living. The discretionary spending is what you have to take tight control of. You’ll have to shift money from this category if your essential expenses continue to rise.

Take care of your needs first.

Set clear financial priorities.

Make a list of things you will need to use your money for, and then prioritize them from most important to least important. Even during inflation you can still get the important things you want. The means to it will be keeping your eyes on your prize while controlling yourself.

Pay off your consumer debt. Why further erode the buying power of the money you earn by accumulating high interest on your outstanding debts? You are, in effect, spending the money before you ever earned it, leaving you with less to spend on the higher costs of the things you need.

Know your needs from your wants. When the urge to spend seems irresistible, ask yourself, “Do I really need this?” This little phrase will help you pull yourself back from the edge. You may have to say it to yourself multiple times. At the same time, remind yourself of your priorities. Accomplishing them will be more satisfying and lead to fewer regret-filled sleepless nights.

Be creative and flexible. Look for ways to make the most of the money you have. This could involve everything from buying certain items or foods only when they are on special offer, trying to spend the least amount you can over a weekend and still have a great time, forming a group of people to cook meals together, or sharing a holiday with a friend to keep the costs reasonable.

The only limitation is your own creativity. Make surviving inflation interesting for yourself.
 

Friday, 18th November 2011

Tags:   alvin hall  /  inflation  /  money  /  savings  /  money guide  /  economy
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