An old woman, grey yet energetic, comes out of the grocery store smiling as she has done every month for the past five years. Her grocery list hasn’t changed a bit neither has the fantastic feeling that comes with buying them. Yet, she noticed that she has been spending more than her budget. Something isn’t adding up. When she reached home, she goes through her purchases and sees that the current prices of the groceries are different from that of previous years. Lo and Behold, their prices have increased over the years. Yet, it’s the same quantity, same company, so what has changed, she lamented.
We’ve experienced something like this when buying a product or another. That’s inflation in action.
What causes the price rise then?
The rise in prices is caused by factors that can be classified as either:
- Demand-pull and
When the supply of goods can’t meet the demand for such goods, we have demand-pull inflation. This could mean two things:
- the supply got reduced and can’t meet the demand,
- there is an increase in demand for goods that the supply can’t meet up with the increase in the demand.
An increase in the cost of goods might be caused by an increase in the cost of producing such goods. For example, an increase arises due to the rise in the cost of raw materials, restrictions from regulators, or sanctions.
When the cost of production of a good increase, manufacturers usually pass down the cost for consumers to bear to maintain profitability
From either perspective, inflation makes the cost of goods rise, thus decreasing the value of money.
The value of money or the purchasing power is the amount *insert your currency* can purchase.
A dollar today is worth more than a dollar tomorrow.
With the effect inflation has on the economy, it is essential that individuals also know how inflation affects their financial decisions. While inflation may have varying effects at an individual scale, it tends to work in two ways.
For low-income individuals: Low-income persons have less disposable income than others and may sometimes struggle to pay their bills. They usually have liquid assets- cash and cash equivalents. Thus, inflation erodes the value of their wealth. Nominal numbers won’t change, but the value of the dollar drops.
For high-income individuals: They not only have more disposable income, but they also have more assets—stocks, real estate, and other business interests. Inflation makes them enjoy the benefit of owning stocks of businesses with pricing power and increasing profit margins. If profit margins are rising, companies’ prices for their products increase faster than increases in production costs.
In a nutshell, a low-income person who would spend most of his income on his needs—food, healthcare, rent, etc. sees an increase in expenses as the prices of goods increase with inflation.
For an individual who is well off, he can spend a limited amount on these while still having enough to invest. Therefore mitigating the effect inflation has on his spending while also enjoying an increase in asset income/value.
While a country’s inflation might be low or high, it is usually nominal because the inflation rate is usually the aggregate of all sectors of the economy.
On the other hand, personal inflation is the decline in a person’s purchasing power over time without any decrease in income. When a person has the same income, the quantity of what one can buy reduces.
To understand how this works on a personal level. Here are the ways to go about it:
- What is your total take-home amount (income)
- How much do you spend? What is your budget?
- How much do you save and invest?
- Compare them with the previous five years.
When you compare the difference between the five years, you have a general trend that looks like this:
- Income might increase slightly, in some cases might not increase at all;
- Your expenses increase, at least with the rate of inflation
This means you spend more money not necessarily on more things. It could be the same items but their prices have increased. Which then translates to having a bigger budget.
Inflation essentially makes you spend more on less or the same number of things. Makes your budget bloat and shrinks your income.
When your income shrinks or remains stagnant, you get closer to budget deficit as your expenses increase. In effect, inflation is pushing you closer to debt.
To illustrate this further,
Mr. A is has two jobs; a 9-5 and a side hustle. He lives alone in a small studio downtown. Here is his breakdown of income and expenses.
Using the expenses chart, an inflation of 3% per annum translates to a 0.25% increase per month. This is what the monthly expenses look after five years.
MONTHLY EXPENSES AFTER 5 YEARS
This slight increase every month has a compounding effect over five years.
Expenses increase from $1610.00 to $1909.00 per month, which is a difference of $299.00. This difference is approximately 15% of his total income!
If, within the same period, Mr. A is unable to increase his income, he would see a decrease in the extra money he once had to invest. And if in 10 years Mr. A hasn’t had any increase to his income north of $500, his expenses will be more than his income. While this is rare for people in the workforce, this is a possibility for retired people.
While the above budget and inflation rate are imaginary, in the sense that goods and services do not uniformly increase, sometimes - most times, some expenses grow faster than others, in fact, faster than the inflation rate.
When some expenses increase faster than others, a person’s cost would determine how much of one’s budget would increase. Beyond that, the inflation rate of the items that have the highest allocation in your budget can have enormous effects.
To illustrate this let's assign different inflation rates to different items on the monthly expenses and compare them with a different budget but with the same rates.
From the two budgets, we have the same total monthly expenses. Only the allocation to items are different. Now we compare the said effect on inflation on both budgets with each item having the same rates in both budgets.
BUDGET A (after inflation)
BUDGET B (after inflation)
We find out that the total is different even though the two budgets have the same amount of expenses and the same inflation rates for each item. This difference even though not much, could compound over the years to a large sums.
As explained earlier, despite the average inflation rate is 3.8%, most items on the budget exceeded the average, this is a more holistic view as it shows how inflation works on individual items and on the budget as a whole.
The difference in total amount spent is caused by the difference in the allocation of the expenses. Notice that food has a higher budget allocation and the highest inflation rate in the budget. Hence the large difference in the amount spent on food.
If you have more proportion of your income spent on an item, the inflation rate of that item has more effect on your budget than other items and their inflation rates.
- inflation is a general rise in the price level of an economy over a period of time Tweet
- inflation is either Demand-pull or Cost-push
- the value of money or the purchasing power is amount of goods and services a unit of currency can purchase. And it goes down as inflation rates rise
- a dollar today is worth more than a dollar tomorrow
- owning assets reduce the adverse effects of inflation
- personal inflation is the rate at which your expenses increase without adding new goods or services Tweet
- personal inflation may defer from the nation's inflation rate due to individual item inflation rates and your budget allocation.
Thanks to Yusuf and Aisha for reading drafts of this