How does Inflation Affect your Cost of Living


The business section of the newspapers and the news channels are always concerned about the inflation rates, how it is rising, how it falling, how the central bank is taking steps to keep it under control, Wholesale Price Index or Consumer Price Index, but why should we be bothered about inflation at all? How does inflation concern us, or how does inflation affect our standard of living?

What is Inflation? Basically, inflation is the change in the prices of goods and services in a year. Inflation occurs when the demand and supply in an economy are not in balance. In an inflationary situation, the prices of the goods and services rise, and the value of currency reduces, i.e. each unit of currency now will buy lesser goods and services. With the prices rising and falling every now and then, you really need to understand your country’s inflationary situation to plan out your living for the present and the future.

As the costs of consumer goods and services increases, your purchasing power is reducing. What is cost of living? This number averages the cost of an accepted standard of living that includes food, housing, transportation, taxes and healthcare. The cost of living is based on the prices of things in that particular area. So even if you are earning $10,000, living in India would probably be fine, but you can definitely not live New York City!

When I say your purchasing power reduces, what I mean is that the product that cost you 0 bucks, about 10 years, would definitely cost you a lot in today’s date. If inflation rises by 3% in a year, you would need 3% more of the income you are currently earning to live the way you were living until last year, since you won’t be buying these goods or services at last year’s prices. But if you are earning the same, and everything else is simply getting expensive, you will have to spending more than the usual just to keep up with your lifestyle, or maybe cut down a few items. You may have to withdraw some of your savings, to meet the rising expenses.

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Most countries use Consumer Price Index as the index for measuring the inflation rate. A consumer price index measures changes in the price level of a market basket of consumer goods and services purchased by households. So certain products aren’t included in this CPI, and even when the overall inflation rate may be low, the prices of these products may have risen, adding onto your cost of living.

The other thing the inflation rate is affecting is your investment returns. For example if your stock returned 3% and the current inflation rate is 5%, then your real investment returns would be -2%. Or consider an investment of $100 you made, with an interest rate of 10%, so after a year you are to get $110. But if the inflation rate is positive, say, 5%, your interest rate will reduce to become 5% and you would actually get back only $105. Even though $110 was your nominal return, your actual or real return is lesser due to the positive inflation rate.

Even though the richer households are not much affected, rising inflation hits the poor and the middle-class. So the best way to tackle a high inflation rate is to cut down unnecessary expenses and save as much as you can, because the future may turn out to be costlier.

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Mark Holland

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