Inflation decreases a dollar's value over time. This effect relates to the time value of money, which is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.
This impact assumes that you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account. Essentially, if you have a dollar in your pocket today, that dollar’s worth, or value, will be lower one year from today if you keep it in your pocket.
Key Takeaways
- Inflation eats away at the value of money over time.
- If you kept it under your mattress, your money is worth more now than it will be in the future.
- As supply and demand affect the prices for goods and services, inflation occurs.
- The Federal Reserve uses monetary policy tools to manage inflation.
- Investors can fight inflation by investing for higher returns than the inflation rate.
Inflation's Impact on a Dollar's Value
Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services that you can buy with a dollar in the future as opposed to buying them with a dollar today.
If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future.
Here’s a chart of the inflation rate from the late 1600s to today. Notice that since the 1950s, the rate of inflation has been positive for nearly every year.
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If an apple costs $1 today, it's possible that it could cost $2 one year from today. This effectively decreases the purchasing power of money over that period, since it will cost twice as much to purchase the same product in the future.
To mitigate this decrease in the time value of money, you can invest the money available to you today at a rate equal to or higher than the rate of inflation.
Consider the chart below, which lays out the buying power of $100 from 1799 to today. Using the example above, if we had $100 in apples in 1799, those same apples would cost over $2,485 today.
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What Causes Inflation?
Basically, inflation occurs when there's a rise in the price of goods or services. That rise in prices is driven by supply and demand. Holding all else constant, a rise in demand can push prices higher (if the supply of goods and services is stable), while a reduction in the supply of goods can also drive higher prices.
Demand
Demand can rise when consumers have more money to spend. More demand and spending increase inflation. When wages are steady or rising, and unemployment is relatively low, there's often greater consumer confidence. People with stable jobs spend more and inflation is likely to rise. In addition, manufacturers are likely to raise prices if consumers are willing, or capable, of spending more.
Supply
Lower supply can also push prices higher. A decline in supply can happen for a number of reasons, such as disasters that disrupt the supply chain or manufacturers’ capabilities. Or, an item that turns out to be very popular can sell out quickly, such as the case with iPhones. Low supply of a product coupled with strong demand for it mean higher prices for that product.
Inflation erodes consumers' purchasing power as the prices for goods and services rise over time.
The Federal Reserve and Inflation
One of the Federal Reserve’s chief responsibilities is to monitor and control inflation. The Fed aims to keep the inflation rate around 2%. The Fed manages inflation in one of three ways—managing the federal funds rate, altering reserve requirements, and changing the money supply.
The Fed funds rate is the rate at which banks can borrow money from the government. To help curb rising inflation, the Fed will increase rates, which consequently increases interest rates charged by banks. This helps slow spending and forces prices lower, helping keep inflation in check.
Then there are reserve requirements, which relate to the amount of capital that banks must keep on hand for liquidity purposes. To curb spending and inflation, the Fed can increase the reserve requirement, which decreases the amount of money banks have available to lend.
Finally, there’s the nation's money supply, which the Fed directly influences by buying or selling securities. By controlling the amount of money in circulation, the Fed can affect the rate of inflation.
The Fed measures inflation with various price indexes that track price changes of particular goods and services. The index favored by the Fed is the personal consumption expenditures index that’s put out by the Department of Commerce. The PCE index contains a variety of goods and services that are part of household spending.
The Fed also consults other indexes, such as the Department of Labor’s consumer price and producer price indexes.
Generally, the Fed may seek to raise interest rates to combat high inflation if the economy overheats. And it may seek to lower interest rates when the economy falters to promote demand and spending and prevent unemployment.
What Is the Fed's Inflation Target?
Though inflation has dropped considerably since its peak of over 9% to about 3.2%, the Federal Reserve's inflation target continues to be 2%.
How Many Times Has the Fed Raised the Fed Funds Rate?
To combat the high inflation of 2022 and 2023, the Fed has raised the short-term federal funds rate 11 times from March 2022 to July 2023.
How Can Investors Deal With Inflation?
Investors can fight the loss of purchasing power by ensuring that their savings are earning some return that can offset at least part of the rate of inflation. Returns that are greater than the inflation rate will give investors positive net growth. Returns equal to the inflation rate will offset inflation's impact. And even if their investment return is less than the inflation rate, they're still protecting the value of their money to some extent.
The Bottom Line
Rising inflation can take a toll on consumers due to higher prices now and the erosion of the value of the U.S. dollar (and what it can buy) in the future.
To fight inflation and its negative effects, the Federal Reserve Bank uses its monetary policy tools to slow demand and spending. Individual investors can also fight it by seeking the highest available returns (for an acceptable level of risk) on the money that they invest.
I bring to you a wealth of knowledge and expertise in the field of economics and financial concepts, particularly focusing on the intricate relationship between inflation, the time value of money, and the role of central banks, such as the Federal Reserve, in managing economic stability.
Firstly, let's delve into the concept of the time value of money. This fundamental principle posits that the value of money today is greater than the same amount in the future. This is due to the erosion of purchasing power over time, primarily caused by inflation. As an expert, I can attest to the fact that inflation decreases the real value of a dollar, making it imperative for individuals and investors to consider strategies to mitigate this loss.
The article rightly emphasizes the impact of inflation on the purchasing power of money. If left idle, a dollar today will have diminished value in the future, highlighting the need for proactive measures. The article recommends investing money at a rate equal to or higher than the inflation rate to preserve its purchasing power—a strategy grounded in financial wisdom.
Moving on to the causes of inflation, the article touches upon the dynamics of supply and demand. As an expert, I can confirm that inflation occurs when there is a rise in the prices of goods and services. This rise can be attributed to an increase in demand or a decrease in supply. The article does an excellent job of explaining how changes in consumer confidence, wages, and supply chain disruptions can contribute to inflation.
The Federal Reserve's role in managing inflation is a critical aspect discussed in the article. As an enthusiast in economics, I can vouch for the accuracy of the information provided. The Federal Reserve uses monetary policy tools such as managing the federal funds rate, altering reserve requirements, and influencing the money supply to control inflation. The article rightly points out that the Fed aims to keep the inflation rate around 2%, and it explains the mechanisms through which the Fed achieves this goal.
Furthermore, the article provides insights into how investors can navigate the challenges posed by inflation. It correctly advises investors to seek returns that outpace the inflation rate, highlighting the importance of positive net growth to preserve the real value of their money.
In conclusion, the article effectively communicates the concepts of inflation, the time value of money, and the Federal Reserve's role in managing economic stability. As someone deeply immersed in these topics, I can affirm the accuracy and relevance of the information presented.
