What is inflation? To really understand inflation, you need to know what money is and why we use it. Money represents the value of hard work and the production of things that other people want to use. The measurement of this production or hard work is done with units of money. If I spend $20 to buy a can opener, that $20 represents an hour of work serving food in a restaurant, for example. You can see this by looking at a job that pays hourly wages, and then taking those wages and buying things you don’t produce to get all the things you need to live. The backbone of this idea is the exchange and exchange of goods, because it may not be possible to do everything you need yourself.
The assumption people make is that $20 today is $20 tomorrow. Actually, it is not. The prices of things are constantly changing, and the value that this $20 can buy depends on when you use it and what you buy with it. Do you want proof? Look at the price of food, gas, education, rent, utilities, and many household goods and services over time. Prices go up most of the time for most items and this $20 is buying less and less each year. To see a drastic comparison, in 1920, $20 bought you a suit, a belt, and a new pair of shoes. Today this $20 can only buy you one belt. Inflation is when prices go up and more money is needed to buy things of the same quantity and quality. Deflation is when the same money buys more things of the same quantity and quality. This has been happening with technology, clothing, and internet shopping as a few examples.
Inflation is also defined as the rate at which prices rise and the rate at which the value of the dollar falls. What can you do about it? In the 1970s and 1980s, he was getting raises at his job each year that were at least equal to the rate of inflation, or the rate at which the value of the dollar was falling. This allowed him to buy the same things for the same amount of work that he was doing. As an example, if you earned $20 an hour in 1970, you can buy 5 liters of milk for $20. The following year the price of milk increased to $21 and his salary would increase to $21 and he can buy the same amount of milk for one hour of work. If you are an investor, you would put money in a bank account with an interest rate equal to or higher than inflation so that you can buy the same or more assets with the capital you have invested. If you were a landlord, you would increase your rent by 5% to offset your 5% increase in expenses, so your rental property would generate the same amount of profit despite inflation.
What happens if you don’t get this raise or if the investments aren’t paying a return equal to inflation? The value of the work you are doing becomes less valuable, or the amount of goods you can purchase for your work becomes less. The value of investment capital also loses value over time. If this trend continues for a long period of time, your job will not allow you to buy much and you will be close to slavery. Once the capital decreases to the point that nothing can be bought with it, this is called insolvency.
The solution is to find labor, investments or assets that maintain their purchasing power despite inflation. For work, it is to get wages that would increase every year. For investments, the income yield or growth rate must be greater than inflation. For assets, these would be physical, tangible things that would still be useful despite the value of the currency. These are goods that people always need: food, water, shelter, land, productive capacity (tools, equipment), and precious metals to use as currency.
How do you know the effect that inflation is having on your purchasing power? You need to see how much your income or capital increases each year compared to how much the things you need increase in price each year. The government publishes an average number called the Consumer Price Index (CPI) which is supposed to capture this for the average person. To understand your personal impact, you need to estimate your income and expense amounts as they change over time, preferences, and earning capacity.