Q

What’s inflation and how does it affect your purchasing power?

A

Inflation decreases the value of a dollar — meaning you can buy less with that dollar over time.

Inflation isn’t a particularly complicated concept. All the stuff you spend money on — be it milk, rent, hairspray or movie tickets — can be bundled up together to come up with what’s called “cost of living.” As the cost of living rises — a number reflected in what’s called the consumer price index, or CPI — that dollar that used to buy two candy bars now barely buys one. That’s inflation.

So how does inflation affect you? It affects you greatly if your salary doesn’t at least rise with the rate of inflation, meaning that even if you make the same salary, you won’t be able to afford to buy as much. (Since the government started tracking it in 1915, the average inflation rate in Canada has been 3.15 percent.) It will adversely affect those who keep a great deal of cash on hand since over time, what might have once looked like a sizeable amount of money will look considerably smaller, since the money simply won’t buy nearly what it once would.

If you have your money sitting in a savings account it won’t do much better. Inflation rates are normally higher than the interest rate on a savings account. This means if you’re only getting a 1% return on your savings and the inflation rate is 2% — you’re effectively loosing money. That’s one of the many reasons people choose to start investing rather than save it or keep it under the mattress.

Historically the stock market (S&P 500) has grown by an average of 7% per year. Although the market has risen and fallen, it trended upwards over time. This means it has outpaced inflation. That trend may not continue — with investing there are no guarantees and past performance does not mean you’ll get the same results in the future. That said, if you already have a rainy day fund set aside in a savings account or other form of high interest savings, consider investing in a diversified portfolio as an option for your additional income.

The only beneficiaries of inflation are those with negative assets — that is, those in debt. Someone who owes a huge amount of money should celebrate higher than normal inflation since it means that even if the number of dollars she owes hasn’t changed, the value of what she actually owes is objectively lower thanks to the power of inflation.

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