Summary
- Inflation means prices rise over time, while deflation signifies falling prices.
- Supply and demand factors drive price changes, leading to inflation or deflation.
- The U.S. Federal Reserve aims for a 2% natural inflation rate and individuals need income or investments growing by at least 2% to counteract inflation.
- Investing is crucial to keep up with inflation and preserve purchasing power.
Inflation is the concept that prices move higher over time. On the flip side, deflation is the concept of falling prices. In our Supply and Demand lesson, we addressed how supply and demand can drive prices higher and lower, translating to how supply and demand factors can result in inflation and deflation.
The U.S. Federal Reserve, which helps set interest rates in the U.S., tries to adjust its monetary policies so that prices have a natural inflation rate of around 2%. So if the price of everything goes up 2% every year, you need to have income or investments that are growing by at least 2%. That’s just to stay even with inflation every year. If your income or investments do not increase that much each year, you are effectively losing money to inflation.
So, at an absolute minimum, you need to try to increase your income and investment return to at least keep up with anticipated inflation. Hiding your money in your mattress, where it does not earn anything, is not an option to keep up with inflation. If someone held their money, say $1, in a mattress 100 years ago when soda was $0.25 and took it out now to buy a soda at $1.50, they couldn’t buy that soda. If that person instead invested that $1 and returned 5% each year for 100 years, that person would have over $131.50. That’s enough for plenty of sodas.
Key Concept: If you want to keep up with inflation, you need to invest in something. If you can get interest on your checking or savings account that at least matches inflation, that is a great start. If you can’t, you may need to expand your investment options.