You remember when you were a kid and a chocolate bar cost far less than it does today? This phenomenon happens because of inflation, and the same thing that happens to chocolate bars happens to your money too.
I don’t see inflation talked about as much as I think it should be, especially when it comes to personal finance. This blows my mind because every year all money, including yours, loses a bit of value to inflation. In fact, since 1993 the Bank of Canada has been openly committed to an inflation target of 1-3%, meaning a little inflation is good for the economy in general, just not your savings.
Inflation is a big, complicated, abstract concept which is why I think it is so often overlooked. But after looking at various ‘high interest rate’ savings accounts, I started to think that people not familiar with inflation are losing money when they think they’re gaining money.
To better illustrate inflation, let me offer a basic example:
You are king/queen of a small village of 100 people. To avoid everyone bartering, you decide to create a currency based on gold, you have one kilogram of gold and you decide to create coins for your 100 subjects. So you take your gold and make 200 royal coins. Your people are happy, they now have something that allows them to price their goods and services more accurately than if they were trading for other goods and services.
Your plan works well. The villagers find it easier to buy and sell goods, and thus easier to make money. But you only have 200 coins, and your inventive villagers start coming up with new ways to make money, new goods and services to sell and you soon notice a coin shortage in your economy. Your more successful inhabitants are saving coins from their successful business endeavors, taking fewer and fewer coins out of general circulation. You discover that of the 200 coins you made, only 100 seem to be exchanging hands regularly, making the coins more scarce, and thus more valuable to the point where one coin can buy a villager enough grain to feed a mule for a whole year.
So you decide to buy another kilogram of gold (perhaps by introducing taxes) and mint another 200 coins, doubling the amount of coins in your economy. Because so many more coins are now in general circulation, they are no longer scarce and one coin will now only buy a villager enough grain to feed a mule for only half a year. Those who saved coins before you introduced more coins would find that their savings have effectively been halved because they can now only buy half the goods for the money they had saved.
By doubling the amount of coins available, you’ve effectively halved the monetary value of all your coins. Inflation went up 100%!
The Canadian economy works on the same principle, except it isn’t based on gold and is more sophisticated. In addition to introducing new money into an economy, rising costs in manufacturing or a commodity scarcity are also big factors in inflation.
The Bank of Canada is the institution that manages the Canadian Dollar; it issues new money and sets the interest rates. It also has a target inflation rate of 1-3% that it uses to steer the economy.
The Bank of Canada measures inflation by measuring the change in the Consumer Price Index, which is a “basket” of thousands of consumer goods (for example: a kilogram of Royal Gala Apples, a new Toyota Camry, a pair of Levis 501s, etc.) and tracks the price changes. In fact, the Bank of Canada has a handy inflation calculator that lets you see exactly what inflation has been. Using this calculator, I can see that in 2014, inflation was at 0.97%. In 2013 inflation was 1.48%. Since 2000, inflation has gone up 32.94% with an average annual inflation rate of 1.92%.
Looking at the inflation calculator, I see that $100 in 2000 would get me the same amount of goods then as $132.94 in 2015. Put another way, a chocolate bar that cost $1 in 2000 would cost you $1.33 in 2015.
Inflation means each year $1 will buy you less, so if you have money just sitting in a bank account collecting little or no interest, you aren’t losing money, but as the cost of goods grows, the value of your money does not, and you will be able to afford less things as the years go on with the same amount of money.
To use another example, if $11,000 was a median annual salary in 1950, and I worked for a year and managed to bank my entire salary (somehow avoiding taxes and the cost of living), I would have $11,000 in the bank today. Which won’t get me nearly as much as if I had today’s median annual salary of $45,000 in the bank.
If you have $1000 in the bank today, what do you think you’ll be able to buy with it in another fifteen years?
Next week, I’m going to look at various savings accounts and see how those “high interest” rates stand when you apply inflation.