Item prices tend to keep on rising as a result of higher production costs as well as supply and demand forces. Inflation is triggered by the average rise of prices in the economy. The cost of living rises with rising inflation, and vice versa. It's important to tighten your belt and keep a sharp eye on your household budget during periods of high inflation to make ends meet.
Inflation directly affects the standard of living because if inflation is rising, prices in the economy are rising, in turn increasing the cost of living.
Purchasing Power Shortages
Inflation erodes your purchasing power because your money loses value as you have to spend more to buy fewer items. In fact, you may have to cut back on some purchases because your income is no longer sufficient to meet all your needs. If you are a business owner, the decline of consumer spending power translates to falling sales and dwindling profits.
Preparing for a Savings Slump
It's only possible to save when you have enough disposable income. However, rising prices may exhaust your income more quickly and leave you with nothing left over to spend. You may even have to withdraw some of your savings to meet the rising costs of living. There is also little to no motivation to save during periods of high inflation because of the reduced purchasing power of your savings. This may expose you to a lower standard of living when you retire should you end up with insufficient savings to live off of.
The Impact of Shrinking Returns
If you're living off your savings in retirement you may have to endure a reduced standard of living if inflation rises because high inflation, when factored alongside your income taxes, reduces the returns on your lifetime savings. For example, if you invested in a retirement benefits fund offering annual returns at a rate of five percent, tax deductions and a low inflation rate will have little impact on your earnings. However, if inflation rises rapidly your net savings returns will slide significantly, leaving you with less money to spend.
Ups and Downs
Lenders charge either fixed or variable interest rates on their loan and mortgage products. Unlike fixed interest rates, variable rates fluctuate with changes in economic conditions. The Federal Reserve raises interest rates during periods of high inflation to remove excess money from the market and curb further inflation. This subsequently increases the interest rates for your variable interest loan or mortgage. You'll then have to commit more income towards the repayment of your loan or mortgage, distorting your household budget.
- The Board of Governors of the Federal Reserve System: What is Inflation and How Does the Federal Reserve Evaluate Changes in the Rate of Inflation?
- Forbes: What is Inflation Good For?
- Journal of Economics, Business and Management, Vol. 3, No. 7, July 2015. "An Examination on the Determinants of Inflation," Page 678. Accessed March 19, 2020.
- U.S Census. "Median and Average Sales Prices of New Homes Sold in United States," Accessed March 19, 2020.
- U.S. Energy Information Administration. "Short-term Energy Outlook: Real Prices Viewer." Select "imported Crude Oil Prices," Select "Monthly." Download Excel Spreadsheet. Open tab titled "Crude Oil-M." Use second column "Imported Crude Oil Price Nominal." Accessed March 19, 2020.
- Office of Energy Efficiency and Renewable Energy. "Historical Gas Prices," Accessed March 19, 2020.
- Federal Reserve Board of Governors. “What Are the Federal Reserve's Objectives in Conducting Monetary Policy?” Accessed March 19, 2020.
- Federal Reserve Bank of Cleveland. "Inflation 101," Accessed March 17, 2020.
Paul Cole-Ingait is a professional accountant and financial advisor. He has been working as a senior accountant for leading multinational firms in Europe and Asia since 2007. Cole-Ingait holds a Bachelor of Science Degree in accounting and finance and Master of Business Administration degree from the University of Birmingham.