You know that old expression about money burning a hole in your pocket? At the current rate of inflation in 2022, it’s the money itself that’s on fire: your dollar today is worth some 8% less than it was a year ago. With inflation reaching its highest rate in decades, it’s all the more important to understand the details of inflation so you can confidently make budgeting and investment plans around the current environment.
For help managing your portfolio and your finances through the current high inflationary period, consider working with a financial advisor.
To put it more simply, inflation is when the prices of goods and services go up across an entire sector over a set period of time. If one store starts charging more for crackers, that isn’t inflation; if the price of crackers goes up at grocery stores across the country, on the other hand, that is inflation.
The International Monetary Fund defines inflation like this:
Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated – for certain goods, such as food, or for services, such as a haircut, for example. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.
With inflation, a dollar has less purchasing power than it did. That money is, in effect, worth less in what can be bought with it as prices rise.
What Causes Inflation?
There are a number of factors that can cause inflation, including:
- A growing economy. In a growing or expanding economy, unemployment goes down and wages go up. This means more people have more money available to spend, including on non-necessities and luxuries. Consequently, suppliers increase prices, which allows them to hire more people, putting more money into the system, creating an inflationary cycle.
- Expansion of money supply. If there is more money in circulation, it becomes worth less. Thus, prices go up.
- Government regulation. If the government imposes new laws or tariffs making it more expensive to produce or import goods, those prices will be passed on to consumers, creating inflation.
- Exchange rate changes. If the U.S. dollar dips relative to foreign currency, cash has less value and prices go up.
Consequences of Inflation
Now that we know what inflation is and what can cause it, let’s look at the consequences of inflation. The most obvious is that with prices raised, American families can afford to buy less. This is especially obvious when it comes to grocery stores, where rising prices can really impact a families bottom line.
Inflation going up can also boost incomes. There is a concept known as the Phillips Curve that shows this relationship. The other side of the coin, though, is that inflation can boost unemployment, as each new worker will demand higher wages, given that money is worth less. Existing employees will also need raises, as most businesses give cost of living raises based on inflation.
Government Response to Inflation in 2022
The government’s main response to inflation this year has been a consistent increase to interest rates. The Federal Reserve has already raised interest rates numerous times this year, with more increases expected to come this year and in 2023. Raising interest rates makes it harder to borrow money, decreasing the money supply and potentially combating inflation. The problem, though, is that this could lead to a recession.
The other response are tax adjustments. The standard tax deduction for 2023 went up to $13,850 for individuals, $20,800 for heads of households and $27,700 for married couples filing jointly. Those are increases of $900, $1,400 and $1,800 respectively. There are also new tax brackets.
The Bottom Line
Inflation is an economic force where prices go up. Various things can cause inflation, including an increase to the money supply, a booming economy and new government regulations. Impacts of inflation include boosted incomes and higher unemployment. This year, the Federal Reserve has raised interest rates to fight inflation, which could cause a recession.
Tips for Dealing With Inflation
- A financial advisor will be able to help you deal with inflation in your portfolio. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- There are certain investments that can take advantage of inflation, including gold and savings bonds.
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