Fundamentals 101 – What is Inflation
Have you ever wondered what is inflation? It's the reason why things constantly get more expensive over time, and is the reason why your parents were able to buy a house at such a low price compared to the cost today.
It's also the reason why your tuition was so expensive.
What is inflation
At its most simple term, inflation is the decrease in purchasing power of your money over time. You may have been able to buy a landed property for RM100,000 50 years ago, but today, that same property will cost you probably 3,000,000+.
The reason inflation exists is because the government is always printing money (have you ever notice that the coins you get have a year on them?). After printing the money, the government either directly spends it (say on building a new highway or LRT line) or allows banks to borrow it (which then the banks lend it to you at a higher interest rate).
Because all of a sudden there's more money moving in the economy, prices of goods and services will go up so they can make more money. Eventually, the income should also increase slightly each year (though most income will not keep up with the inflation rate).
This is considered a good situation.
A bad situation is when the government prints way more money. This happened back in the 1930s when Germany, overloaded with debt, decided to print their money to repay it. Because they printed so much, the value of their money dropped so much that it suddenly took a wheelbarrow of cash to buy one pair of shoes.
If this happens, other countries will stop accepting the money because they know the money is essentially worthless (an example is there's no point in lending you the money instead of buying a house if the money you give back to me cannot even buy a pair of shoes).
Why is inflation important
Inflation is important for you to understand because, unlike compound interest (which works for you, inflation works against you.
The average inflation rate the last 100 years is about 3.15% which means each year, your money is worth 3.15% less.
That means having RM100 today will only be able to buy you RM96.85 tomorrow.
In other words, you are losing money by keeping your money as cash and in a bank (if your bank isn't paying you more than 3.15% on average each year)
Want to see how much purchasing power is lost due to inflation? Check out the calculator we built!
What should you do with this information
Now that you know the disruptive power of inflation, you should at the minimum find investments that can give you returns similar to inflation. In most of these cases, you will need to look for some corporate bond fund (ie unit trust) to be able to meet your needs. That way, your money will still retain its buying power in the future when you truly need it.