Inflation in simple terms means the loss in the value of currency or in mirror-effect, it is an increase in the price of Commodities, Services and Assets. This happens when demand for anything is more than its supply. Supply of any Commodity or Service or Asset is limited and increases gradually with the growth in the economy.
However, demand increases in greater proportion with the growth in population, younger demographic mix, increase in per capita income and growth in money supply (liquidity). In simple terms, when there is more money in the system chasing finite commodities, services or Assets, the price of the Chasee obviously increases. This inflation rate is higher in Emerging Nations as compared to Developed nations due to the fact that growth in demand is higher than growth in supply in Emerging Nations.
The above examples have been taken of basic commodities only which are approximately indicated by Government Inflation figures of CPI (Consumer Price Inflation). However, when we consider the inflation in Education cost, Medical treatment costs and Lifestyle related expenses (branded clothes, latest gadgets, lavish vacations, high end cars, etc.), the rate is much higher. Below is the simple graph that can be used to get approximate multiples at different inflation rates over a period of 40 years:
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 or Interest Income remains flat, prices rise. Consequently, their disposable income is reduced as day-to-day expenses consume an ever growing portion of their income. While in the short run, a 2%-3% variation because of inflation may not seem like a lot on your regular expenses, but it can leave a strong impact in the long run, especially when planning for retirement.
Thus, to protect the value of your Savings, the post-tax return on Investments must at least beat the inflation rate. Failing that, the inflation will keep on eating into the Principal value of Investments. What it means is that your Savings will not be worth the same; it will be lower than the rate at which the price of goods and services around you are growing.
Equities have often been a good investment, relative to inflation over the very long term. This is because companies can raise prices for their products when their costs increase in an inflationary environment. You could beat inflation by putting your money in equities, which has the potential to beat inflation in the long run. If you feel investments in equity are risky; think again because the impact of inflation on the value of your money is far riskier. When investing, you should factor inflation-adjusted returns to have real growth in your savings. To counter the impact of inflation, factor it when planning financial goals and invest accordingly.