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An Easy Example Of How Inflation Works


We share an easy example of how inflation works and how it will affect you, and your cup of kopi-o.

Milton Friedman, a Nobel Laureate, once said: “Inflation is always and everywhere a monetary phenomenon”.

With major central banks printing money excessively, it is safe to assume that inflation will continue to remain in Singapore. Annual inflation rates over the past 5 years has been 3.12%.

Putting your money in a saving account at the local banks will most definitely erode the “purchasing power” of your money over time.  But how does this “purchasing power” of your dollar erode? We use a simple example here to illustrate the concept.

 

Assumption:

1. Deposit S$1.00 into a savings account today

2. A cup of coffee at your local hawker cost S$1.00 today

3. Average inflation will be 3.12% (Source: MAS Statistics) for the next 10 years

4. Average interest rate of 10 leading banks is 0.1% per year (Source: MAS Statistics) for the next 10 years

 

Year

Price of Coffee (S$)

Value in your savings account (S$)

0

1.000

1.000

1

1.031

1.001

2

1.063

1.003

3

1.097

1.004

4

1.131

1.005

5

1.166

1.006

6

1.202

1.008

7

1.240

1.009

8

1.279

1.010

9

1.319

1.012

10

1.360

1.013

In ten years’ time, the amount of money in our saving accounts would only enable us to purchase 0.74 cups of coffee as compared to 1 cup today. This is as good as making a loss in investment of 26%, at least as far as coffee is concern.

 

Hedging Against Inflation

Hedging against inflation is not as straight forward as it may seem. The simple logic is that you can’t just go out there and buy a cup of coffee today at $1, and expect to keep  it for consumption 10 years later. The same goes for a whole load of other things in life that you would need to purchase and consume immediately.

That is why commodities such as gold and silver are highly sought after as assets that can help protect an investor against inflation. These are seen as products with prices that will track inflation. Put bluntly, if 1 gram of gold is able to buy 75 cups of coffee today, investors believe it will still be able to buy 75 cups of coffee in 10 years.

Don’t get us wrong, parking your money in the bank is not a bad thing. In fact, having enough savings equivalent to 6 months of expenses is very important. Everyone should always set aside an amount of money which they can readily withdraw almost immediately for “ rainy days”.

However, we recommend a portfolio for each individual, which includes a mixture of liquid cash and financial instruments such as stocks and bonds. This portfolio should be in accordance to each individual’s appetite for risk. Monitor this portfolio of yours closely and make necessary changes to it as and when needed so as to achieve a target you set for yourself in the future. You may read more on asset allocation for portfolio.

For a healthy economy, inflation is here to stay. A deflation may signal a decrease in prices for everything. You may perceive it as a good thing for consumers, but that is only in the short run. If putting money at home can increase “purchasing power”, nobody would have the incentive to invest, thus leading to an unstable economy that has little investments and thus, high unemployment.

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