Impact of Inflation on your money

Personal Finance

In this article you will read about

  • What is inflation
  • Impact of inflation on your finance
  • Ways to counter inflation

At some point or the other, we all have heard of inflation and felt its impact, because inflation effectively shrinks the value of your money over time. Inflation is often described as too many rupees chasing too few good and services. What this means is that when spending is faster than production of goods and services, the purchasing power of rupee declines because inflation goes up. You can view inflation as the opposite of compound interest, because takes away what compound interest gives. It thus becomes important to find returns on your savings and investments to beat inflation.

Let us assume you put Rs 1 lakh in a deposit that earns 7% interest. At the same time, prices are going up at a 7% rate. In such a scenario, your earnings from the savings will keep pace with the inflation rate. However, if your savings earn lesser than the inflation rate, the value of your savings goes down or you lose purchasing power. What it means is that your Rs 1 lakh will not be worth the same; it will be lower than the rate at which the price of goods and services around you are growing.

Inflation affects your standard of living because it can reduce your spending power. Retirees are often greatly affected by inflation because many retirees live on a fixed income. While their pension income remains flat, prices rise. Consequently, their disposable income is reduced as day-to-day expenses consume an ever growing portion of their income. While in the short run, a 2%-3% variation because of inflation may not seem a lot on your regular expenses, but it can leave a strong impact in the long run, especially when planning for retirement.

Suppose your current monthly cost of living is Rs 1 lakh, and you are planning to retire 25 years later. If you do not factor inflation, you may land up living under extreme duress because at 5% inflation rate, after 25 years you will need Rs 3.38 lakh to be able to match the present Rs 1 lakh monthly cost of living.

Inflation’s impact on your future

Monthly Expenses

Rs 1 lakh

Rs 1 lakh

Rs 1 lakh

Rs 1 lakh

Inflation rate

4%

5%

6%

7%

Monthly Funds required

2,66,584

3,38,635

4,29,187

5,42,743

When saving and investing towards your financial goals, if you don’t factor inflation; you may need to compromise on the goal. So, instead of say a 2 week planned Europe tour five years from now, you may at best do so for a week. For those who have retired, not planning inflation can be catastrophic; you may need to move to smaller home and spend less on day-to-day routine expenses. You could also curb the impact of inflation by putting your money into savings and investments that beat inflation.

Equities have often been a good investment, relative to inflation over the very long term. This is because companies can raise prices for their products when their costs increase in an inflationary environment. You could beat inflation by putting your money in equities, which has the potential to beat inflation in the long run. If you feel investments in equity are risky; think again because the impact of inflation on the value of your money is far riskier. When investing, you should factor inflation-adjusted returns to have real growth in your savings. To counter the impact of inflation, factor it when planning financial goals and invest accordingly.

Next steps

  1. Factor inflation when setting financial goals
  2. Save and invest in equity and equity-oriented instruments
  3. Aim for positive inflation-adjusted return from investments

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