Inflation is the increase in the price level of goods and services over time. When price increase, the same amount of money you make buys less. In other words, inflation reduces your purchasing power. Think back on what your money used to buy ten years ago and you will see what I mean.

What causes inflation?

Inflation is caused by a growth in money supply. When money supply grows disproportionately with real economic growth, the prices of goods also increase. Printing more money without a corresponding increase in real wealth puts everybody in a worse state.

The government tries to manage inflation by controlling money supply. Most developed countries try to keep inflation rate at no more than 3%. The ability to control money supply introduces a hidden form of taxation. This is why I call inflation the silent tax because even though you do not pay this money directly to the government, you do end up paying it by paying more for the same goods.

Adverse effects of inflation

The 2 major adverse effects of inflation are as follows:

1. The opportunity cost of holding money increases
2. Customers hoard goods for fear of increasing prices

    

Combating inflation

To combat inflation you cannot rely on savings for putting away extra cash. You need to find investments that rise faster than the inflation rate. The interest rate you get from savings account may be fine for short term cash needs but are too low to fight the erosion of wealth due to inflation. If inflation grows at the rate of 3%, your investments have to earn more than 3% just to keep up with the cost of living.

Investing in income producing assets is another good way to combat inflation. However, do your leg work by educating yourself before investing. Without proper education, you may end up in a worse state than you were before investing. Your investment strategies should match your personal investment philosophies and style. This looks different for everyone and developing your philosophies takes time and education.