In the finance section of your newspaper, “inflation” is a dirty word. It makes your money worth less and it makes the economy slow down. Despite all that, though, some people like it. Why do some people benefit from inflation?
If there were only two ounces of aluminum in the world, aluminum would be an extremely valuable metal. In reality, though, there is a huge supply of aluminum, which makes it very cheap. A country’s currency behaves in roughly the same way. If there were only a small amount of U.S. dollars in the world, each of those dollars would purchase a lot of goods. In reality, though, there are trillions of U.S. dollars, so it takes two of them just to get you a box of Pop Tarts.
To make matters worse, the supply of U.S. dollars increases over time. And the more dollars there are, the less each individual dollar will buy. Today, you might buy a low-end hamburger for $1.00, but next year it might cost $1.02, the following year $1.05, and so forth as the buying power of the U.S. dollar declines and the price of goods rises. Inflation is “the rate at which the general level of prices for goods and services is rising.” [Source: Yahoo Financial Glossary. Top News Archive – Yahoo! Finance. N.p., n.d. Web. 19 Nov. 2010. ]
Inflation can reduce the value of your assets. For example, if you have a million dollars sitting in a checking account earning 1% interest and inflation is 3% annually, you are losing 2% of your savings each year. The number of dollars in your account increases by 1% each year, so you might feel like you are making money, but that increase is outpaced by the 3% annual decline in buying power for each of those dollars.
So why would anyone want inflation? Imagine that you recently bought a home. You paid the smallest down payment possible and took out a 30-year fixed-rate mortgage with a monthly payment of $1,500 (meaning that you will have to pay $1,500 every month for the next 30 years). Paying $1,500 each month is like paying 1,500 hamburgers to the bank each month (because in our example above, hamburgers cost $1 each). But what if we have 20% inflation over the course of the next few years? Hamburgers will then cost $1.20 each, and your mortgage payment will be the equivalent of only 1,250 hamburgers. So the real value of the amount you have to pay to the bank each month will go down by 20%.
Meanwhile, the value of the house (all non-inflation factors being held constant) will actually increase by the 20% inflation. If the house was initially worth $300,000, it will now be worth $360,000. And when inflation occurs, salaries go up. So, if you were making $8,000 per month initially, after 20% inflation you will likely be making about $9,600 per month. In summary, then, it will be easier to make the monthly payment on your mortgage, and the value of your asset (the house) will have increased substantially.
Inflation hurts people who hold cash and cash equivalents. For those who hold debt and/or non-cash assets, however, it can actually be beneficial.
Yahoo Financial Glossary. Top News Archive – Yahoo! Finance. N.p., n.d. Web. 19 Nov. 2010. .