What is Inflation and How Does It Work?

Ah, inflation. The thief in the night that slowly drains the purchasing power of your money. It’s an overlooked threat to our finances and it’s often overlooked because it is usually well-managed in the developed world. But what is it, exactly? And how does it even work? First, let’s look into the idea of “purchasing power”, “price”, and “value” from an economist’s perspective.

Purchasing Power – The amount of goods and services a given amount of currency can buy

Price – The amount of currency needed to be exchanged to acquire a good or service

Value – The worth of an item or service

Price refers to how much currency would typically be exchanged for a given good or service. For instance, a car may have a price of $25,000 or getting nails done may have a price of $65. Those prices let us know how many dollars we need to give up to get those things.

However, this concept becomes a bit wonky when translating the price of money. First of all, one wouldn’t pursue the price of money because we don’t typically buy money! At least, we aren’t online shopping for it. We need to know the VALUE of money. This is where “purchasing power” comes in.

Economists use the term “purchasing power” to describe the price/value of money instead. In 1986, an easily digestible example of this was created called the “Big Mac Index”. It simply measures how much a Big Max costs in different currencies over different years and that effectively measures purchasing power. (Big Mac Index/digestible pun was pretty good, huh?)

PHEW! Now, if you aren’t confused yet, we can move on to inflation and what it means, but let’s summarize.

Purchasing power is how we describe the value of money. Price is the number of dollars needed to buy something. Value is the inherent worth of an item or service. Purchasing power and price are more important as it relates to inflation.

Describing inflation is super easy if you understand the first section of this article. Inflation is simply the decrease in purchasing power of a dollar. Obviously, we don’t see dollars leaving our bank accounts randomly to correct for this. We see prices going up on most goods and services.

I brought the three concepts up before because this is the explanation of inflation:

Inflation is the increase in price of a good even though the value of that good has not changed.

The Big Mac recipe wasn’t changed to include diamonds and rubies. Car prices aren’t up because the cost of materials needed to add flying capabilities. Purchasing power of a dollar has decreased which means businesses need to increase prices to receive the same level of value.

I won’t spend a ton of time here as we’ve described inflation in pretty technical terms so far but two areas inflation shows up is in your salary and your investments.

If you receive a 2% raise and inflation is 5%, you actually just received a pay cut of 3%. The math is a bit more complicated than that but you can use this concept as a rule of thumb. Be vigilant in high inflationary times to negotiate your salary.

Inflation hits heavy in your investments, as well. Most people without a background in finance look at what is called a “nominal return” or whatever their statement says their investment return is. That number doesn’t account for inflation which is why many professionals discuss “real return”. Real return is the investment return after considering inflation.

If your investment return was 8% in your 401K and inflation was 7%, you actually had a real return of 1%. Your purchasing power only increased 1%.

Warren Buffett once stated that inflation is the worst tax because it has the potential to eliminate most or all of your investment return.

There are more ways we see inflation in the economy instead of simple price changes. We are in the era of creative, invented buzzwords to describe phenomena we see in the world so here are a few of these phenomena.

Shrinkflation

Shrinkflation is the reduced size of packaging and contents for the same price. I used to work for Pepperidge Farms back in college delivering goldfish and cookies to grocery stores in my area. I knew all the products by weight, number of servings, product type, you name it. I was shocked to realize more recently that the size of the products they sell are, by weight, smaller than they were when I delivered them. Guess what? The prices were the same.

Skimpflation

Skimpflation refers to many reductions made by a business but namely to quality and quantity of services offered. We’ve seen a wave of this as we’ve transitioned into the subscription economy instead of the transaction economy, but we’ve also seen more of it as a way for companies to merely survive.

We’ve all had a service that used to include a feature that was then removed and sold as an upcharge service. Additionally, you may have gone to your favorite restaurant somewhere and realized the last time just wasn’t as good. Companies will reduce costs as a way to fight increasing prices as a way to keep the same amount of profits without increasing prices.