Inflation is when the general level of prices increase over time. Consumer price index (CPI) is the most common measure of inflation. When doing financial planning, inflation is of vital concern as it not only affect what we pay for but also how much we earn. We need more income when prices increase because our purchasing power drops.
Let’s assume you earn $3,000/mth in 2007 and your salary increase to $3,202/mth in 2010 which is an annual growth of 2.2%. If inflation averaged 2.8% each year, your purchasing power would have decreased even though your income increases. Your income need to be $3,259/mth just to keep pace with inflation.
Interest rates will increase due to inflation and it will drive up the cost of borrowing money as lenders seek compensation for their eroding purchasing power. This will in turn mean higher mortgage payments, higher monthly car installments, and so on. Inflation will also have a detrimental effect on stock, bond prices and retirement plans.
Are you doing anything to keep pace with inflation?
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