How to Beat Inflation.
This may seem strange at first, because if inflation is defined as an increase in the general level of prices in an economy over time, then measuring it would seem to be as simple as keeping track of the prices. However, this is not always the case, as inflation can take many forms. The substitution problem is one of the biggest issues plaguing modern inflation measurements because when we measure inflation, what we’re really interested in is how the declining purchasing power of currency is likely to impact our future expenses,
“Get a better idea”
So we can get a better idea of how much money we’ll need to save up for a new car 10 years from now or how much of a savings account we’ll need for a vacation. It is common knowledge that the consumer price index (also known as the cpi) measures inflation by looking at the prices of more than 90,000 different goods and services. However, most of us will never be able to afford all of those items, so the cpi’s stated annual inflation rate may not feel accurate to the average consumer.
Although, the cpi is the most widely used of the inflation metrics we’ll be looking at today, it’s not without debate. Consumer price indexes (CPI) used to measure inflation by comparing the change in the price of a fixed basket of goods and services over time; for example, if a carton of eggs cost $2 last year and $2.05 today, inflation would equal to 5% for the eggs; the government performed this comparison for numerous goods and services and assigned weights based on how important they were perceived to be.
These values differ quite wildly from the values assigned to them in the early days of cpi they also periodically change the products or services that are being compared to better reflect consumer behavior some examples include temporarily dropping things like refrigerators and new car sales from the list during the world war ii era when production of those items was temporarily banned and finally they also adjust the actual price changes observed.
In the early 1930s, food and clothing made up about half of the weight of the cpi’s equation due to the fact that they consumed roughly the same amount of people’s budget at the time, but that is not always true today, and that may cause a fixed basket fixed weight approach to be ineffective in many cases. The personal consumption expenditures price index, or pce, is the second measure of inflation we’ll look at today. It is calculated by the Bureau of Economic Analysis and shows the prices businesses are actually selling items for,
Rather than the prices consumers are paying for them, as the cpi shows. On the surface, this may seem like exactly the same thing, because if I buy a bag of carrots for two dollars at the local supermarket, then doesn’t that mean t In some cases, a consumer’s price for an item and the price a business is charging for an item are the same, but in other cases, the price a consumer pays for an item and the price a business is charging for an item are different, such as in the case of medical costs, where a co-pay is often required for visits to the doctor’s office.
The cpi would not reflect this discrepancy but the pce would. because it looks at what the business in this case the doctor is actually charging instead of just what the consumer is paying out of pocket on the bright side this may give us a better idea of how costs are changing over time since it takes into account more factors which is probably why the fed considers the core pce which is just the pce excluding volatile food and energy categories to be its main measure of inflation when attempting to maintain its two percent per year target though
It does take other metrics into account on the other hand it may be less relevant to ordinary consumers both because its focus is less on what people are paying and more on what things actually cost and the fact that just like with the cpi it may not actually reflect any individual consumers purchasing behavior the third measure of inflation we’ll look at today is the gdp deflator this is a less well-known measure and it goes about things a little bit differently than the previous two instead of looking at a basket of goods and services it calculates the change in prices from one period to the next across the entire economy
It does this by dividing nominal gdp by real gdp and then multiplying by 100 to convert to a percentage gdp as many of you know is simply a measure of the total monetary value of all goods and services sold in a country excluding exports over a specific period of time its value changes due to one of two factors either the price of the goods and services in an economy change from one period to the next
Or the amount of products and services sold in an economy changes so if you wanted to determine how much prices have changed you simply need to isolate that factor from the number of goods and services that are sold in a given period economists do this by recalculating the total monetary value of sales in the current period using prices from a prior period so in other words by multiplying the sales volume of the us in 2021 by 2020 prices
And comparing it to the current year’s actual gdp you can work backwards and solve for the price inflation experienced that year on the one hand the gdp deflator is very useful because it compares the entire economy against itself from a previous period Aside from monitoring changes in prices, it can also record changes in consumer spending habits, which solve the substitution problem that afflicted the early CPI. This implies that it can be a fairly accurate indicator of how inflation affects individuals on an economy-wide basis.
For most people, the gdp deflator is more difficult to calculate and understand than a few hundred or thousand goods and services, because you need to keep track of all of them and not just their prices, but their sales volume as well. Additionally, since the gdp deflator is focused on an economy-wide scope, it doesn’t do as well at helping us to understand the changing costs of any individual pr.
Today, we’ll take a look at the quantity theory of money as a gauge of inflation. Instead of trying to predict an inflation rate, quantity theory of money focuses on how the amount of money in circulation influences the price of goods. A simple example is shown in the following equation. The amount of money in circulation divided by the velocity of money equals the price of the products sold When the money printers are running and the supply of money is doubled but people are cooped up and not spending as they normally would because the velocity of money is slowed, prices will not necessarily double. The same could be said if companies were more productive.
It is also important to consider the velocity of money, or how many times each dollar changes hands in a certain period of time, and then how many products or services are sold. It’s impossible to use the theory to predict your financial future since we don’t know when and in what amounts money will be created or taken from circulation, nor do we know how those other variables of the equation will play out during those periods.
The relative worth of other currencies and types of money, such as commodities and precious metals, is the sixth indicator of inflation we’ll examine today. Some argue that because commodities and precious metals are likely to be among the first parts of the economy whose prices are influenced by inflation, we should instead use metrics like the cpi and the pce, which are considered lagging indicators. One disadvantage of this strategy is that the price of commodities in precious metals might fluctuate for a variety of causes, not all of which are related to an increase in prices throughout the whole economy.
It would be more difficult to plan out your personal finances if inflation directly affected the pricing of commodities and precious metals, which would make it even more difficult to see where prices are moving the most. A currency’s relative value to other currencies is another popular method for gauging inflation, but there are many reasons why a currency may appreciate or depreciate relative to other currencies that are not related to inflation in the broader economy and it doesn’t really tell you what inflation is like in the home country’s currency.
for instance a country that regularly imports more than it exports can see the value of its currency decline over time and this can be a contributing factor to inflation just look at Lebanon though it’s rarely the only factor at play and at least over the extremely long term there is some evidence that commodity prices reflect inflation it’s just that they have some notable drawbacks when trying to capture an isolated inflation rate especially in the here.
And now the sixth and final measurement that we’ll look at today is budgetary inflation put simply this is just the amount your spending increases from one year to another on the plus side this approach is the only method that is tailored to your specific financial situation on downside your data point of one and people’s lives and spending habits tend to change in different phases of their life think of the different things that you spend money on when you have kids for instance.
So when used in isolation this approach does very little to help you plan out your finances long term because you have no frame of reference for how these lifestyle changes will affect your future spending so those are six common measures of inflation none of them do a perfect job of allowing you to see how changing prices could affect you both now and down the road
But thankfully when viewed together you can give yourself a better idea of what’s going on in the here and now as well as what may be coming down the road for you personally for instance you could combine your own personal spending history with historical inflation rates measured by the cpi for specific categories that you have spent little or no money on before such
As child care or medical costs as you age in order to get a better idea of what your costs might look like when the time comes for you to start spending money in those areas without sacrificing the personalized aspects that can really only be measured by looking at your own financial history.