Inflation, to put it simply, occurs when prices increase and your money buys less. The Consumer Price Index is a measure of inflation, based on the rise or fall in cost of a hypothetical sample market basket of consumer goods. While you as a consumer feel its impact most in the form of rising prices, inflation has additional, far reaching effects. Most notable among these are the impact of inflation, whether actual or expected at some time in the near future, on the lending industry and savings.
Causes of inflation
There are a number of theories as to the cause of inflation. The first posits that inflation is caused in large measure by demand vs. supply. When demand (the number of consumers wishing to purchase) exceeds supply (the amount of goods available for sale), prices are pulled up, as sellers take advantage of the situation.
A second theory claims that prices are increased in response to increased costs of doing business. Yet another theory hypothesizes that inflation occurs when the government permits an overabundance of money to be created, resulting in a fall in its value in relation to the amount of goods and services that it will buy.
Effect of inflation on loans
When the rate of inflation increases, interest rates are raised accordingly. This makes existing variable mortgage loans more difficult to pay off, while fixed rate mortgages are unaffected. New home ownership loans will be more expensive, causing many would be home buyers to purchase less expensive homes than they had intended or perhaps to delay pursuing their purchase altogether.
Personal loans and other forms of credit will also cost more in terms of interest, encouraging consumers to curtail their spending. Once again, major purchase, such as automobiles or home appliances, will be reduced in scale or postponed.
Effect of inflation on savings
Inflation might seem to have a positive effect on your savings if they are stowed in an interest bearing account, and not under your mattress. However, bank interest on savings historically has not kept up with the rate of inflation. What’s more, recently bank interest rates have been at an all-time low.
What this means in simple terms is that, even though you may find that your savings have increased 10 years from now due to interest, price hikes due to inflation will still reduce your future purchasing power. Add to that the fact that the interest on your savings is considered taxable income and it’s no wonder that some individuals choose to invest in commodities such as gold, real estate or stocks and bonds rather than a savings account.