What Is Inflation And How Does It Affect Your Financial Situation?

While the media and most Americans today are talking about how inflation is ravaging our economy lately, few truly understand what inflation actually is, how it works, and most importantly, how to adapt to minimize its adverse effects in their lives.

So in this article, I’m going to break all of that down in a way that anyone can understand, and I’m also going to share some advice on how to protect yourself from the financial erosion caused by inflation.

Knowledge on this critical economic factor will be key to surviving, or even thriving through the more challenging and costly economy we will all face in the coming years. 

What Is Inflation?

Let’s start with the basics — in the simplest definition, which is the one most people use, inflation is when the cost of things goes up.

While that is “technically” correct, a more accurate definition of inflation is when, through economic policy decisions, the value or purchasing power of your dollar is reduced. We saw this recently with the obscene pandemic spending enacted by our government, less recently with the 2008 housing collapse, as well as numerous smaller injections of currency. 

This often spurs some spending, and can sometimes help jumpstart a weak economy, but it rarely works out that way. The bigger problem, however, is the side effects that come with quantitative easing. Want to take a guess what the worst one is?

It’s inflation. 

Yep. Every time the government injects more currency into circulation, it causes the value of your dollar to decline. That is inflation, and our own government is directly causing it. 

It’s also worth noting that despite claims from some pundits and politicians, inflation is not caused by “greedy businesses” and in fact, cannot be caused by any business, no matter how “greedy” the people who run it might be, because they have no control over our currency supply.

Now, you may have seen some of these pundits and politicians claim that, “corporations are reaping record profits,” as evidence that they’re to blame, but that claim demonstrates a complete lack of financial literacy. 

To understand why, we can look at a simple financial formula.

Let’s say you run a business that did 1 million dollars in revenue last year, your costs were $700,000, and your profit was $300,000. Like everyone else, you and your business are affected by inflation, so your costs go up as well. For this example, let's assume your costs went up 15% due to inflation. That means your business now must raise prices by at least 15% just to maintain the status quo. So your revenue will now be about 1.15 million dollars, your costs will be $805,000, and your profit will be $345,000. 

Guess what — you’re now “reaping record profits” too, according to those pundits and politicians, even though you aren’t any better off than you were last year.

Inflation is caused by our government injecting more currency into the economy. 

To put this all in perspective, the U.S. dollar has lost 87% of its purchasing power since abandoning the gold standard 1971. This, essentially, unlimited printing of the US dollar is exactly what caused real estate and certain other assets to skyrocket in price, driving inflation up in the process.

How Is Inflation Calculated?

This is where things get tricky. 

The formula for calculating inflation has changed numerous times over the years, making historical comparisons difficult if not impossible. But beyond that, the government uses several different variables they can swap out to enable them to report inflation numbers that paint a rosier picture than what we’re facing in the real world. 

Inflation today is calculated using the Consumer Price Index, or CPI, which measures the price change over time for a basket of goods and services. The Bureau of Labor Statistics collects the prices of some 94,000 items from a sample of goods and services to assemble its representative basket, but here’s the kicker — they can (and do) swap out any of these goods and services with a substitute, so the score is essentially meaningless. Additionally, the CPI metrics also exclude food and energy, which together, make up a large portion of most American’s budgets.

How Does Inflation Affect Cost Of Living?

As the cost of everything goes up, every business is forced to raise prices to survive. This puts a strain on budgets everywhere, forcing people to find ways to cut costs. 

While this is the right choice, it also creates a new problem — those cuts lead to revenue losses for businesses, which means pay cuts or even layoffs for the employees of those businesses. This leads to further reduced spending, which means further loss of revenue to businesses, which then leads to more pay cuts and layoffs.

It doesn’t take a genius to see how this can quickly spiral out of control. 

To put this in perspective, I want to talk about the Rule of 72, specifically as it pertains to inflation. 

This formula can be used to see how many years it will take to cut the purchasing power of your dollar in half. You can do this by dividing 72 by the current inflation rate. For example, if inflation is around 4%, as it’s currently being reported, you would divide 72 by the rate of inflation to get 18 years until the purchasing power of your money is reduced by 50%.

72/4 = 18

The Rule of 72 makes it easy to see how inflation quickly erodes the value of the money you’ve worked so hard to earn.

How Does Inflation Affect Saving And Investing?

Inflation makes it more difficult to earn a good return on your investments, and it makes saving a losing endeavor. Let me explain what I mean by that. 

When it comes to investing, it is more difficult to achieve typical returns because the economy is more strained and inflation eats away at the value of your dollar. Most investments tend to perform poorly during these inflationary periods, making it a wiser move to invest in things that act as a hedge against inflation. That might include conventional real estate (but avoid new development or speculative deals), gold, and even Treasury bills. The rate of return will typically be lower, but these investments are far less risky during these periods.

When it comes to saving, it’s important to remember that cash loses the most value compared to other assets during inflationary periods. Cash on hand, perhaps in a safe at your home, is the worst in this regard, but cash in a bank isn’t much better because interest rates are typically 5% or less. Technically, our current reported inflation rate is 3.7%, but that number is highly manipulated and inaccurate. You can see that inflation is actually much higher every time you have to purchase something.

Don't get me wrong — you absolutely need to have some savings for emergencies, but the majority of your money should be in investments that will appreciate faster than inflation will erode their value.

How Does Inflation Affect Business?

While some people think of businesses as these giant entities floating high above all of the challenges ordinary people face, that’s not the case at all.

The truth is that most businesses are relatively small, run by ordinary people like you and me, and the owners struggle with the same challenges everyone else faces, and then some.

Businesses are particularly hard hit by inflation because it affects their costs, forcing them to raise prices, which often leads to a loss of customers. And unlike individuals, businesses have a harder time cutting costs because their costs are often necessary to run the business. This often forces business owners to cut from their largest cost, which is payroll.