Your standard of living is largely based on two factors: your income and your expenses. Inflation occurs when day-to-day expenses rise. An imbalance in the relationship between supply and demand causes inflation. Prices rise as increasing numbers of people compete to buy a limited number of goods.
Periods of inflation are common in functioning free market economies. However, inflation can have a profound effect on your standard of living due to how your purchasing power declines.
Inflation can hurt your standard of living by cutting the purchasing power of your income while increasing your daily expenses. You may have to take on debt to get by, which can have interest charges that further harm your finances.
Inflation and the CPI
Economists and government officials use a variety of methods to track inflation, but the Consumer Price Index is commonly used as a measure of inflation in the United States. The CPI charts fluctuations in the prices being paid by urban consumers for food, housing, education, clothing and various services. CPI data do not include income taxes, although they do include sales and excise tax.
Inflation causes the CPI to rise, while deflation has the opposite effect. Historically, prices gradually rise over time, but inflation becomes a concern when prices rise rapidly.
Reduced Spending Power
Inflation affects your standard of living because it can reduce your spending power. Retirees are often greatly affected by inflation because many retirees live on a fixed income. While their pension income remains flat, prices rise. Consequently, their disposable income is reduced as day-to-day expenses consume an ever growing portion of their income.
Wage earners experience the same problem if wages stay flat or if inflation outpaces wage increases. You avoid the ravages of inflation if your income level rises at a pace that exceeds the rate of inflation.
Impact on Your Finances
When faced with inflation, you can either curb your spending or borrow the funds needed to maintain your current standard of living. If you choose the latter, debt payments eventually erode your earnings in much the same way as inflation. You can combat a small decrease in your spending power by eliminating discretionary expenses such as gym memberships or magazine subscriptions. A more dramatic loss of spending power could force you to move into a smaller home or to rely on public transportation rather than a personal vehicle.
Hyperinflation occurs when price hikes spiral out of control. In such an economy, you may exhaust your entire budget buying basic essentials such as food and water.
How Governments Manage Risk
Governments attempt to combat inflation by raising interest rates. As borrowing costs rise, consumers and businesses have less disposable income. As demand for goods dries up, retailers slash prices to offload surplus inventory.
Governments can also address inflation by manipulating currency prices. This affects the cost of imports and exports. If a particular currency increases in value, the cost of imports decreases, and this helps to bring down inflation.
However, governments have no control over energy prices and commodities. An increase in the cost of oil has a knock-on effect that causes transportation costs to rise. Businesses' profit margins shrink, so companies raise prices. Any subsequent measures taken by the government serve to treat the symptoms rather than the root cause of inflation.