What Is Inflation?
Inflation refers to how the price for goods and services increases over time. For example, a loaf of bread that would have cost $2 10 years ago might cost $4 today. Even though you can't nail down exactly what inflation rates will be in the future, understanding how inflation works allows you to plan for your future financial goals.
Inflation measures the change in cost over a broad range of items, not just a one or two, because it measures how the cost of living changes for an average person or family. For example, inflation measures the cost of goods like food, clothing, energy and electronics, and services like haircuts, insurance and housing. During any given period, some of these items will go up in cost more than others; inflation refers to the average increase in price of such goods and services.
Because different types of goods see prices inflate at varying rates, inflation doesn't have the same impact on everyone. Instead, it affects people differently depending on what they purchase. For example, if food prices are going up rapidly, a family of four is likely to feel a bigger hit than someone living alone because it has more mouths to feed. Alternatively, if a single person has a long commute and gas prices rise drastically, that will have a bigger impact on his budget than someone who has a minimal commute or works from home.
Planning for Inflation
Inflation affects how you plan your future savings goals, such as buying a home or saving for retirement. For example, say you want to buy a home that costs $200,000 today in five years. If after five years, you have $200,000 in your savings account, you're likely to be short funds because the price of the home may have increased. If inflation amounts to 2 percent per year, you're going to need more than $220,000 in five years.
Relative Purchasing Power
The fact that goods and services are likely to cost more in the future than they do today means that your dollar likely won't buy as much in the future as it can right now. As a result, it's important for you to measure your net worth relative to what it can buy, rather than just as a raw number. For example, say you have $20,000 your retirement account today. If you simply let it set in an account paying 1.5 percent interest for 20 years, you'll have almost $27,000. However, if inflation is 2 percent, you won't be able to buy as much with that $27,000 in 20 years as you could with the $20,000 today.