Fact of life
Taking a look at important terms associated with inflation might help put this financial fact of life in perspective.
The concepts include what inflation and deflation actually are and how it they can skew our perception of the real value of money.
Looking at the bigger picture, moderate inflation is widely seen to be a good thing – and understanding its role in personal finances may make it easier to manage.
Put simply, inflation is a general rise in prices. Inflation doesn’t mean that all prices are rising at the same time (in fact, some may be falling) or at the same rate but that the average price in an agreed basket of goods is going up.2
Down but not out
The opposite of inflation is deflation – a persistent fall in prices. Deflation might avoid some of the challenges associated with inflation but it brings worries of its own, including the risk of debt mounting.3
Index-linking is another term often associated with inflation because one index investments can be linked to is the rate of inflation. They aim to ensure that the purchasing power of the investment does not deteriorate as prices rise.4
One solution economist and writer Chris Dillow gives in a blogpost for savers trying to beat inflation is simply “save more”. He admits it is not an easy solution but points out history shows savings ratios often do rise when inflation is high.5
In five tips for beating inflation, we write that re-investing interest is a key to beating inflation. It protects the nest egg against rising prices. The strategy becomes particularly powerful when interest is added to interest – known as compound interest.6
When negotiating a pay rise, don’t forget to factor in inflation. If your boss offers you a two per cent rise but inflation is four per cent, you will be losing out in real terms. More on money illusion is here.