What is inflation?

The simplest definition is that inflation is a general increase in prices. More specifically, the inflation rate published by most governments is usually a comparison of the price of a selection of goods and services over a one-month, or one-year period. These goods and services are carefully chosen to be representative of those used by most households.

Why is inflation important?

As inflation increases the cost of living rises. Suppose the present rate of inflation is 3%. What that means is that the goods you could buy last year for $100 this year will cost you $103, next year $106, and in ten years time $134. If your income isn't increasing at the same or a greater rate, then you will not be able to live at the standard you currently enjoy. In general it is only the money paid for employment which increases, at least roughly, with inflation. Investments rarely do. And that is why inflation is important to all of us.

What inflation rate should I use in this program?

Ideally you should have some idea of how inflation has varied historically - at least over recent decades - in your part of the world. Then, using that as a basis, estimate a likely average annual rate for the future period you are interested in. As a starting point you might choose to use the current inflation rate figure published by your government's statistics office.

US historical inflation data

Here is an example of historical inflation data. The chart below represents the U.S. inflation rate over the last 90 years. You can see that it has varied widely over even quite short periods, and particularly at times of war, but at present is enjoying relative stability, at a fairly low rate. Similar low rates are being experienced in most Western economies at the present time.

When inflation was 10% or higher, as in the 1970's, everyone was inflation-aware - you couldn't afford not to be. But now, when the rate has fallen to its present low level, most of us are inclined to ignore it altogether. If you are living off income largely derived from your employment then this may not be a problem. Hwever, if you are living off the income generated by savings or investments, with little or no employment-based income, then you really need to recognize the very real impact that even a low level of inflation can have over the longer term. By using this program you will gain a real insight into how inflation can affect your future wealth; and by taking it into account when planning your finances your decisions will be more firmly based on reality.