Look to your grandparents for lessons on inflation
Have you ever heard your grandparents talk about how much cheaper things like gas and groceries used to be when they were young? Well, they’re right — things used to be much cheaper, and prices continue to rise each year! For example, in the fabulous 1950s a burger and fries from McDonald’s cost under 25 cents, compared to today’s price of around $2.50 — that’s a significant price increase!
The idea that the prices of goods and services tend to rise over time is called inflation. For instance, the prices of your grocery list (or fast food tab) may increase each year. Inflation is an important concept not just in our everyday lives, but also for understanding the economy and our investment portfolios.
When the economy is too hot to handle, inflation rises
Economic theory tells us that if the economy is growing at a rate faster than it can handle, it begins to “heat up” and inflation rises. One way to think about this is via a simple example. If the economy is growing rapidly and businesses need to hire more workers, those workers can demand higher wages. Businesses may then pass this on to customers by raising prices. When this occurs across the economy, applied to a variety of products and services, then inflation rises.
When prices rise quicker than wages, the value of your money loses purchasing power. Back to our first example: If you had $10 in 1950, you could get a lot more McDonald’s burgers than today. Although the $10 bill has not changed, it’s purchasing power has decreased.
Inflation tells us about the health of the economy
Not only does inflation affect our everyday lives when we make purchases, but it’s also a key indicator of the health of the economy. When inflation is rising steadily – say, at 2% per year – the economy is thought to be growing in a balanced way. However, if inflation spikes, or even falls (which is called deflation), then there are potential problems with the economy (i.e., a shortage of money in circulation or high unemployment).
Your portfolio may help you keep up with inflation
Inflation is also a reason that it’s important to generate income in your portfolio. If inflation causes the prices of the things you buy to increase by 2% per year, then it’s important to grow the value of your portfolio by 2% per year to match these price increases. Otherwise, the real purchasing power of your savings might actually fall, because the value of your money will stay stagnant as prices throughout the economy increase. Income can be generated through short-term savings accounts, by investing in bonds, through stock dividends, and from other investment vehicles. As you can see, inflation touches everything in our lives from burgers to our investment portfolios.