What You Should Know About Inflation and Deflation

Understanding the value of your Canadian dollar is important, but it can be tricky to know exactly how much that dollar will be worth tomorrow, next week or a year from now. When you know the basics of inflation in a financial sense, you start to understand just how local and global events influence how much your money is worth. Let’s talk a little about what inflation and deflation are and how they impact your finances.

How Inflation Impacts Your Finances

Inflation refers to the increased value of money as well as the increased cost to purchase a product. Most developed nations try to keep inflation to about 2 percent per year as a means to keep the economy on steady ground. If prices increase too much, it may make it more difficult for workers to purchase the goods and services that they need.

More often than not, inflation tends to happen faster in a robust economy. This is why banks will increase interest rates to ensure that the amount of money being processed through the economy stays at a reasonable rate. However, inflation can take place even during a neutral period in the economy or during a recession.

Although inflation may seem like a bad thing for consumers, it can be a good thing in the long-term. As prices go up, wages tend to go up to keep pace with that inflation. This can make the cost of installment loans easier to handle as time goes on. If you were paying $200 a month for a car loan at a time when you made $2,000 a month, you would be paying 10 percent of your income each month for that loan.

However, if your monthly pay increases 2 percent each year, you would make over $2,100 per month after three years. Despite the fact that the payment didn’t change, the percentage of your income going to that payment decreased, which makes the car more affordable in the long run.

What Is Deflation and How Does it Impact Your Finances?

Deflation is the exact opposite of inflation. Instead of prices or wages going up, they go down. When an economy feels deflationary pressure, it could cause unemployment rates to shoot up and fewer goods being purchased by consumers. While lower prices should make consumers want to purchase more goods, they may hold off because they know the prices may be even lower tomorrow or next week.

In addition, they have less money to make purchases with. Therefore, more of their income may go toward paying for gas, food and shelter. As these are considered staple items, the cost of food or the cost of an apartment tends to rise. Apartment prices tend to go higher in weaker economies because renting is often seen as easier than buying for those who may not have a stable income.

While gas prices may go down for awhile, they can only go down so far, and once again, lower incomes may negate any benefit that consumers see. During times of deflation, interest rates on loans tend to go down as a means of encouraging consumers to borrow money and start spending again. The hope is that this will spark demand and get the economy going. Fortunately, the economy rarely goes through deflationary cycles even when economic conditions are as poor as they were during the Great Recession.

What About Stagflation?

When wages stay stagnant despite the costs of goods going up, it is referred to as stagflation. Technically, workers aren’t losing any money in terms of real dollars, but workers lose purchasing power because their money doesn’t get them as much as it did in the past. This is one reason why economists plan for at least 2 percent inflation each year. Doing so allows companies to simply hold the line on wages to effectively cut costs without having to lower wages or let go of workers.

Understanding the concept of inflation and deflation can help you become a better consumer. It can help you determine whether borrowing money is good for your wallet today and in the long-term. When you don’t overspend to get access to capital, you can limit your debt to a reasonable level while ensuring that you have enough cash to pay your bills and cover everyday expenses.