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Don't you miss the days when candy bars cost only a dime? Thanks to inflation, your child would be lucky to buy a gumball today with the same dime that you used for a Snickers® bar when you were a kid.
Inflation is what happens when the same goods and services cost more over time. When we say the cost of living has gone up, what we're really talking about is inflation. High inflation means that prices are going up quickly. Inflation has been around 3% per year lately, but it has been as high as 6% in the 1990s and was even higher in the 1980s.
The "inflation rate" refers to the percentage increase in the costs of goods and services over a year. Most people refer to changes in the Consumer Price Index (CPI) when they talk about the inflation rate.
Why does inflation matter? When you invest or save, you want to earn as much as you can on your money, over and above inflation (as long as you understand and are comfortable with the risks). The amount you earn after subtracting inflation is your "real return." Understanding inflation and your real return will help you understand what your money will buy when you're ready to spend it.
Example. — Let's say you have your eye on a $20,000 car but want to wait until next year to buy it. Here's how inflation might eat into your plans if you don't invest your money carefully:
What you'll save if you put your $20,000 in a savings account that pays 2% interest a year:
$20,000 x 1.02 = $20,400 What your car will cost in a year, if inflation is at 3%:
$20,000 x 1.03 = $20,600 How much more money you'll need at the end of the year:
$20,600 - $20,400 = $200
What's the better investment?
A savings account that pays 10% interest a year when inflation is 8%
A savings account that pays 5% interest a year when inflation is 2%
The better answer is "A savings account that pays 5% interest a year when inflation is 2%". Even though the first investment pays more interest, inflation eats away most of it. After inflation, you'd make 2% (10% - 8% = 2%). You would make more after inflation on the second investment, because your real return would be 3% (5% - 2% = 3%).