Inflation, Deflation, and Why Prices Change

Imagine you put $100 under your mattress in 1990. When you take it out today, you still have $100—but that money can only buy about $50 worth of goods compared to 1990. This is inflation in action, and it's one of the most important economic forces affecting your personal finances.

The Invisible Tax on Your Money

Inflation is often called an "invisible tax" because it reduces your purchasing power without you directly paying anything to the government. Unlike income tax, which you see deducted from your paycheck, inflation works silently in the background, making everything more expensive over time.

To understand how significant this effect is, consider that what $100 could buy in 1990 would cost about $200 today. If you had kept that money in a savings account earning 2% interest, you'd have about $180 today—still not enough to buy what $100 could buy in 1990.

What Causes Inflation?

Inflation happens when the general level of prices rises over time. But what drives this increase? There are several key factors:

Demand-Pull Inflation

This occurs when demand for goods and services exceeds supply. When everyone wants something but there isn't enough to go around, prices rise. We saw this dramatically during the COVID-19 pandemic with items like home exercise equipment, lumber, and computer chips.

Cost-Push Inflation

When the cost of production increases, companies pass those costs on to consumers. Rising oil prices are a classic example—when oil gets more expensive, transportation costs rise, making everything that needs to be shipped more expensive.

Monetary Inflation

When there's more money in circulation, each dollar becomes worth less. This is the classic "too much money chasing too few goods" scenario. Government stimulus payments and central bank money printing can contribute to this type of inflation.

Expectation-Driven Inflation

Sometimes inflation happens simply because people expect it to happen. If workers expect 5% inflation, they demand 5% raises. If companies expect their costs to rise 5%, they raise prices 5%. These expectations can become self-fulfilling prophecies.

Real vs. Nominal Returns

This is where inflation gets personal. When evaluating investments or savings, you need to distinguish between nominal returns (the number you see) and real returns (what you actually gain in purchasing power).

The formula is simple:

Real Return = Nominal Return - Inflation Rate

Let's say your "high-yield" savings account pays 2% interest per year, but inflation is running at 3%. Your nominal return is 2%, but your real return is -1%. You're actually losing purchasing power, even though your account balance is growing.

This is why keeping all your money in cash or low-yield savings accounts is a losing strategy over the long term. You need investments that can grow faster than inflation to preserve and build wealth.

Inflation Around the World

Different countries experience vastly different inflation rates, and these differences have profound effects on people's lives and financial strategies.

India: The Gradual Squeeze

India has historically experienced higher inflation than developed countries, often running at 6-7% annually, with food inflation sometimes reaching 8-10%. This has several effects:

• Middle-class purchasing power is gradually eroded
• Fixed deposits and savings accounts often lose to inflation
• Real estate becomes a primary inflation hedge for many families
• Gold remains popular as a store of value

Argentina: Hyperinflation Horror

Argentina provides a stark example of what happens when inflation gets out of control. In 2023, inflation exceeded 100%, and in some years it has reached over 200%. This creates a completely different economic reality:

• People buy goods immediately upon receiving payment
• The US dollar becomes an unofficial currency
• Long-term financial planning becomes nearly impossible
• Businesses struggle to price their products

United States: The Goldilocks Zone

The US Federal Reserve targets 2% annual inflation—not too hot, not too cold. This level is considered ideal because:

• It's predictable and manageable for consumers and businesses
• It encourages investment over cash hoarding
• It provides room for monetary policy during recessions
• It helps reduce the real burden of debt over time

However, even the US occasionally experiences inflation spikes. In 2021-2022, inflation reached 8-9%, causing significant political and economic disruption.

Deflation: The Other Side of the Coin

While inflation gets most of the attention, deflation—falling prices—can be equally problematic. Japan experienced decades of deflation starting in the 1990s, leading to economic stagnation.

Why Deflation Can Be Dangerous

• Delayed purchases: If prices are falling, people wait to buy, reducing demand and causing more deflation
• Debt burden increases: Fixed debts become more expensive in real terms as prices fall
• Economic spiral: Less spending leads to less production, unemployment, and even less spending
• Investment paralysis: Why invest in assets if their prices are falling?

How Inflation Affects Different Assets

Understanding how inflation affects different types of investments is crucial for building a robust portfolio:

Cash and Bonds

Fixed-income investments are hurt by inflation because their payments don't adjust for rising prices. A bond paying 3% looks great when inflation is 1%, but terrible when inflation is 5%.

Stocks

Stocks can provide some inflation protection because companies can raise prices along with inflation. However, high inflation can hurt stock prices by increasing costs and reducing consumer spending.

Real Estate

Real estate is often considered a good inflation hedge because property values and rents tend to rise with inflation. However, rising interest rates (often used to combat inflation) can hurt real estate prices.

Commodities

Physical commodities like gold, oil, and agricultural products often rise with inflation since they're the actual goods whose prices are increasing.

Strategies for an Inflationary Environment

While you can't control inflation, you can position your finances to deal with it effectively:

Diversify Your Assets

Don't keep all your money in cash or bonds. A diversified portfolio including stocks, real estate, and inflation-protected securities can help preserve purchasing power.

Consider TIPS

Treasury Inflation-Protected Securities (TIPS) are government bonds that adjust their principal based on inflation. They provide direct protection against inflation, though they may underperform in low-inflation environments.

Invest in Yourself

Your earning power is one of your best inflation hedges. Skills, education, and career development can help ensure your income keeps pace with or exceeds inflation.

Fixed-Rate Debt Can Be Your Friend

If you have fixed-rate debt (like a mortgage), inflation actually helps you by making your debt payments cheaper in real terms. A $2,000 mortgage payment is easier to make when your salary has doubled due to inflation.

The Psychology of Inflation

Inflation affects more than just your wallet—it affects your psychology. People tend to notice price increases more than price decreases, and they often blame inflation on whoever is in political power, even though inflation has many causes beyond government policy.

This psychological impact is why central banks work so hard to keep inflation expectations anchored. If people expect high inflation, they behave in ways that create high inflation, making it a self-fulfilling prophecy.

Looking Forward

Inflation will always be with us in some form. The key is understanding how it works and positioning your finances accordingly. This doesn't mean panicking about inflation or trying to time the market—it means building a diversified portfolio that can handle different economic environments.

Remember that moderate inflation (2-3% annually) is actually a sign of a healthy, growing economy. It's only when inflation gets too high or too low that it becomes problematic.

Now that you understand the fundamentals of money, time value, and inflation, we're ready to zoom out and look at the bigger picture: how entire economies work and grow. In the next unit, we'll explore the economic systems that money operates within.